Value of Money

Value of Money:
By the term value of money is meant the purchasing power of money, its buying capacity, i.e.,
the quantity of goods and service a unit of money can buy. Obviously the purchasing power of
money depends upon the level of prices of goods and services to be purchased. Thus the lower
the price level, the greater would be the purchasing power of money and the higher the price
level the lower would be the purchasing power. Hence the purchasing power of money changes
inversely with the price level. Thus the value of money is reciprocal of the price level. To
express symbolically,
V m=1/p
Where, V m= value of money and P= price level.

Quantity theory of money:

a) Classical
- Hume’s versions
- Fisher’s versions
- Income flow versions
b) Neoclassical
- Cambridge cash balance approach
c) Modern version

A. Classical:
I. Hume’s versions
The relationship shown by Dabid Hume, between quantity of money and the value of it is known
as Hume’s version of quantity theory of money. He said that price level depends on the quantity
of money directly and proportionally. This theory is valid only if full employment prevails in the
economy. Main structure of this theory is as follows,
KP = M
Where, K = constant, P = price level and M = quantity of money
II. Fisher’s versions
(Fishers equation/ Fisherian equation/ Cash transaction approach/ Transaction approach/Equation
of exchange/Quantity–velocity approach)
Assumption of the theory:
-The theory works on the long run
- It assumes highly monetized economy where only money is used as a medium of exchange.
- Price level is a passive factor ad depends on the supply of money
-There is proportional relationship between M and M΄.
- V, V΄ and T are constant.
-There is full employment in the economy

The transactions version of the quantity theory of money was provided by the American
economist Irving Fisher in his book- The Purchasing Power of Money (1911). According to
Fisher, “Other things remaining unchanged, as the quantity of money in circulation increases,
the price level also increases in direct proportion and the value of money decreases and vice
versa”.

Fisher’s quantity theory is best explained with the help of his famous equation of exchange:

MV = PT or P = MV/T

Like other commodities, the value of money or the price level is also determined by the
demand and supply of money. aaaa

i. Supply of Money:
The supply of money consists of the quantity of money in existence (M) multiplied by the
number of times this money changes hands, i.e., the velocity of money (V). In Fisher’s equation,
V is the transactions velocity of money which means the average number of times a unit of
money turns over or changes hands to effectuate transactions during a period of time.

Thus, MV refers to the total volume of money in circulation during a period of time. Since
money is only to be used for transaction purposes, total supply of money also forms the total
value of money expenditures in all transactions in the economy during a period of time.
ii. Demand for Money:
Money is demanded not for its own sake (i.e., for hoarding it), but for transaction purposes. The
demand for money is equal to the total market value of all goods and services transacted. It is
obtained by multiplying total amount of things (T) by average price level (P).

Thus, Fisher’s equation of exchange represents equality between the supply of money or the total
value of money expenditures in all transactions and the demand for money or the total value of
all items transacted.

Supply of money = Demand for Money

Or, Total value of money expenditures in all transactions = Total value of all items transacted

MV = PT
Or, P = MV/T
Where,
M is the quantity of money
V is the transaction velocity
P is the price level.
T is the total goods and services transacted.
Irving Fisher further extended the equation of exchange so as to include demand (bank) deposits
(M ¿) and their velocity, (V ¿) in the total supply of money.

Thus, the equation of exchange becomes:

MV + M ¿ V ¿ =PT
MV + M ¿ V ¿
∴ P=
T
The transactions approach to the quantity theory of money maintains that, other things
remaining the same, i.e., if V ¿, M ¿, V ¿, and T remain unchanged, there exists a direct and
proportional relation between M and P. So, price level is directly and value of money is
inversely related with the quantity of money.
Functionally,
P=f ( M ∕ ∕ ) , where M ∕ ∕ =( M + M ¿ )
dP
∴ ∕ ∕
=f ¿ (M ∕ ∕ )>0 ; it indicates that price level is directly related with the quantity of money.
dM
Again,V m =f (M ∕ ∕ ); where V m =value of money
d Vm ∕ ∕
∴
¿
∕ ∕
=g ( M )< 0 ; it indicates inverse relationship between value and the quantity of
dM
money.
This functional relationship is shown in the following figure.
Criticisms of the Theory:

The Fisherian quantity theory has been subjected to severe criticisms by economists.

1. According to Keynes, “The quantity theory of money is a truism.” But it cannot be accepted
today that a certain percentage change in the quantity of money leads to the same percentage
change in the price level.

2. Most of the assumptions of Fisher’s equation are wrong.

3. Fisher’s quantity equation does not show the process through which changes in the amount of
money affect the price level.

4. This theory is static. Many things are assumed to be constant.

5. It does not explain the cyclic fluctuation in prices.

6. It neglects the role of the rate of interest as one of the causative factors between money and
prices.

7. This theory is not applicable in a situation of under employment.

III. Income flow versions

It is an improvement over Fisher’s version. Fisher’s equation considers all secondary and final
goods and services. But only final goods and services are include in national income accounting,
which is considered in income flow version. According to this version, the equation for national
income accounting is,

MV y = P y T y

Or, P y = (MV y /T y)

Where, M = amount of money, V y = income velocity of money (=ration between national

income and money supply = ( P y T y /M=Y/M), T y = amount of final goods and services and P y =
average price level of T y.

V y and T yare considered constant in short run. So, price level is directly and proportionately
related with the amount of money.
Modern Theory (Friedman’s version)

Friedman’s version can be expressed as follows:

M d =f ( U , P , y ,i , ∆ P/P)

Where, M d = demand for money, U = utility of money balance, P = price level, y = level of real
income, i = market rate of interest and ∆ P /P= rate of change in price level.

In short term and developed economy, U, P, i and ∆ P /P remain constant. So the equation is:

M d =f ( y)

Again y is the summation of permanent income y pand temporary income y t . Friedman considers
only y p. So the form of equation is:

M d =f ( y p )

It expresses that demand for money will change proportionately with the change in permanent or
stable income. It is shown in following figure:

The figure implies that M d is proportionately related with y p and not with y t , because the
difference between y p and M d is always uniform.
Criticisms

(i) Though price level, rate of interest, utility of money etc. are initially considered at the
determination of demand for money, they are ultimately neglected. But they have considerable
impact on M d .

(ii) The version will only be specified when there will be no change in the demand for goods and
services. But this is not correct because money is inversely related with i.

(iii) The quantity economists try to maintain economic stability in the long run by monetary
policy. But this may not be possible if changes occur in wage, price and interest rate.

Income theory of money:

a) Income-expenditure approach
b) Saving-investment approach

a) Income-expenditure approach
According to this approach, the real cause of fluctuations in prices is to be found in fluctuations
in the level of aggregate income or expenditure. The concept of income is viewed as ‘money
income’ and ‘real income’. Money income refers to the total income received by the community
in terms of money as some of the factors’ reward during a period. It is also the total expenditure
since one person’s expenditure becomes another person’s income. So, according to Keynes

Y=E

Where, Y = total income and E = total expenditure

Real income refers to the total amount of real goods and services produced by the community in
a given period.

Whereas, the money value of real income is the money income, so,

Y = PO

Where, Y = money income, P = price level and O = total output or real income.

It follows that

P= Y/O

∴ ∆ P=∆(Y /O)
That means price is determined by the ratio of money income to the real income. When Y rises
more rapidly than O, P will tend to rise. If, on the other hand, O rises more rapidly than Y, P may
be expected to fall.

b) Saving and Investment Approach

It says that change in price level depends on total income, which depends on planned saving and
planned investment. Whereas one’s expenditure is the income of other, so,

According to Keynesian hypothesis,

Y=E (i)

Where, Y = total income and E = total expenditure

Again, income earned by people are not fully exhausted for spending, a part of it is saved.
Usually, people use their income for consumption and saving, so,

Y=C+S (ii)

Where, C = consumption expenditure and S = saving

Moreover, if consumption expenditure is excluded from national income, investment will be

achieved, so,

Y–C=I

∴ Y =C+ I (iii)

Where, I = investment expenditure

From equation (ii) and (iii),

C+ S=C+ I

∴ S=I (iv)

It implies that total saving and total investment must be equal in the economy.

But planned/desired saving ( S p) may not planned/desired investment ( I p) though actual saving
may be equal to actual investment because saving depends on the propensity to save and income
while investment depends on possibility of business and trade and profitability.
When,

(a) S p=I p, price level is fixed and consequently value of money is also fixed.

(b) S p > I p, total income decreases and consequently total expenditure decreases, aggregate
demand decreases, price level decreases and value of money will increase.

(c) S p < I p, employment increases and consequently total income increases, total expenditure
increases, aggregate demand increases, price level increases and value of money will decrease.

So, there is no direct relationship between quantity of money and price level.