ewihe Cnapter 20 orn money and Prices -Q tuantity Theory of | wyeotMoney and the Price yal he value of a commodit means what it can be the purchasing power of a commodity. Similarly, the risus of goods and services in general. The purches, ower of money obviously depends on the $rev price level. If the prices are te money if the price level is low, the value of mone is ‘oportional to the price level, or the Value of money is © toy less and its yalue will be Io, Gp The value of money is thus inv pereciprocal of price level, Ww. Conversely, ersely pr QUANTITY THEORY OF MONEY: FISHER’S TRANSACTIONS APPROACH Weare now in position to explain howe sometimes the general level of jieved by the economists that t! zeneral level of prices is determined that is, why at Prices rises and sometimes it declines. Sometime ba: ck it was be-, the quantity of money in the economy is the prime cause of. fluctua- isi the-price level (The theory that oer quantity of money leads to the rise in the general price was effectively put forward by a Civing-Eisher!’ They believed that the greater the quan- fiyofmoney, the higher the level of prices and vice vers \erefore, the theory which linked prices with the quantify of money came to be known as quantity the ve shall first critically examine the ‘Ory of money.) the following analysis ANantity theory of money and thet explain the modern view stout the relationship between money and prices and also the determination of general level of prices. (the juantity theory of money)seeks to explain the value of money in terms of changes in its suantity. Stated in its simplest form, the quantity theory of money saysT ditecly with quantity of money. t the Tevel of prices vanes “Double the quantity of mom the quantity oTmoney. and ober GgSGeE TS willbe twice as high as before, and the value of money one-half. Halve he quamiy oT one-half. Halve the quantity of money anc, other things being equal, prices will be one-half of what they were before and the value of money double.” The theory can also be stated in these words; given increase in the quanti e price level rises proportionately with a quantity of money. Conversely the price level falls proportionately with a ‘eg decease he quant of money other ngs remain the same) here are several forces that determine the value of money and the general price level, The Seneral price level in community is influenced by the foltowing factors: (b) the quantity of money; (©) velocity of circulation of money. 4. Iih® first factor, the vol IS.upon the sup | SQ'cahd services to be exchanged. The greater the amount or supply of goods in an econo! \ttving Fisher, Purchasing Power of Money, Macmillan, 1911. 385 ly, the Scanned with CamScanner>> | I sactions anc snd vice versa. But the classical and MeOClassicay mists who believed in the quantity theory of money assumed that fullemployasent of aj on, | in 7 *386 Macroeconomics : Theory and Policy . re being fully employed, the toyay Suk revailed in the economy. Resources being fully employed, the grap Men Seen fore the fia ade or fansactions) cannot increase. Therefgreeu PS ieleve hen of mony assumed iat 8 ome of ade re remained the sam tp oy The second factor in the determination ot jeral OT sti Press) 7 ie at ot mn is les x ie be noted a ie ay of one mount of creditor deposits created prop sey reney issued by the Gover i , i A unit a™ third factor influencing the price level is the yelocity of circulation. A unit of mone, for ral times in exchange and transactions purposes not once but seve a year. Duri ‘exchanges of goods and services, “e > rupee is ued ive ies ina year forenchange of goods and services, he velocity of ir Hence, the velocity of money is the number of time ney changes hands dure hangs agen Te work oe yeas whi ReITEMYEMETNS er done by the five ppecrwehabasge hands only ‘once each Let us illustrate the quantity theory of mont pee id 8000 i phere 38 ony one gag wheat, which isto be exchanged. The total output of wheat is 2,000 quintals in a year pees | ernment has i 1 t¢ Rs. 25,000 apd no credit is issued yf | that the gov ant has issued money equal | ttle, We further ‘assume that one rupee is used four time for exchange of wheat, Tha Vis ing sett 3,00,000 _ A constant, the price level will rise to the increase is ifthe volume of transactions, ie, output to be exchanged remains constant, the price level rises wi mreconomist Irving Fisher, expressed the relationship betw tof money and the price level in the form of an equation, which is called ‘the =< o Ce Goad 2 Le ne ME oot 0) | tamttctemapsionse) 2 5S where P stands for the average price level: a | T stands for total amount of transactions (or total trade os id services, materials, old goods etc,) Sxarmonant of ged and | M stands for the quantity of money; and ¥ stands for the transactions velocit we i EM canned CamScannerMoney and Prices : Quantity Theory of Money ry equation (1) of (2) is an accounting identi ‘he S008 fe mONEY spent on tansagtions must beeme te eee miosis, because MF reps ~ en eust De equal to PT which represents money received. : the equation of exchan; in : for ysveh 3€ 48 given in eq i Hor jetermination of genera vices by th ons (1) and (2) hasbeen coveted ito gejesmuned >> given level of technology and step gven available resources are se, Thee el fel tenn al sich necessitates vat —————— “oa nih eens vatous pes of anacons, Ano cai sumption that rans oF loci. of circulation (14-is-also-constant, The quantity theot rdingly believed that its Yet quantity theorists accordingly belie ay ofcirulation (V) depends on the methods aiid practices of factor payments such as fre- | We yor wage payments to the Workers, and habits of the people regarding spending their money eones after they receive them, Further, velocity of circulation of money-alse-depends-on-the ‘lopment of banking and credit system, that is, the ways and speed with which cheques are ‘red loans are granted and repaid. According to them, these practices do not change inthe short ‘Gp This assumption is very crucial forthe quantity theory of money because when the quantity of ey i increased thi ‘decline in velocity of circulation of money, then MV may pot sng ifthe decline in V offsets the increase in M: As ares ¢ in M will not affect PY, ‘The quantity th lieve ¢ volutfié of transactions (7)and the changes in it wer ‘pendent of the quantity of money. Further, according fo them, changes in velocity o} afation (PY and price level (P) do not cause any change in volume of transactions except ei fly Thus classical economists who put forward the quantity theory of money believed that the umber Of transactions (which ultimately depends on aggregate real output) does not depend on. "her variables (M, V and P) in the equation of ss ge_Thus we see that the assumption of con- san and Tconverts the equation of exchange which is an accounting identity, into a theory ofthe determination of general price Tevel ‘The quantity of money is fixed by the Goverment end the Central Bank of Sout Further, itisassumed that quantity of money in the economy depends upon the monetary system and policy ‘ofthe central bank and the Government and is assumed to be autonomous of the real forces which | determine the volume of transactions or national output. . ‘Now, with the assumptions that Mand ‘f’temain constant, thé price level P depends upon the quantity of money M; the greater the quantity of M, the hi level of prices. Let us give a tumerical example. Su quantity of igney is ‘an economy, the velocity of circulation of money O is 5; we 1 outpatto be tr (1) is 2,50,000 unifs, the average price level (P) will be: Tore Ifnow, other things remaining the same, the quantity of money is doubled, i.c., increased to eras feco_= SAP annem ATR | s. 10,00,000 then: ; pulls00,000%5 (Rs. 20 perunit 2,50,000 : We thus see that according to the quantity theory of money, price level varies in direct propor- min cause Rina ia iit Scanned with CamScanner OO333 7 Macroeconomics : Theory and Policy ‘ion to the quantity of money. A doubling of the quantity of money (1) will lead to whe price level. Further, since changes in ity of n med 1 depend @utonomous of the price level, the change use “ip the price level” Scanned with CamScanner