Value of Money : A Comparative Study

THE VALUE OF MONEY

The term 'value of money' means the purchasing power

of money. It refers to the general purchasing power of
money
There is an inverse relationship between the level of
prices and the value of money
Vm = 1/p
A rise or fall in the general price level does not mean
that the price of each and every commodity has risen or
fallen in the same proportion. Rather general price
level denotes the central tendency of a group of prices.

THE QUANTITY THEORY OF MONEY

The quantity theory of money explains the

determination of the value of money at any one
time and the variation of this value over periods of
time in terms of changes in the quantity of money.
The theory has got two approaches:

1.

The Transaction Approach or Fisher's Version

2.

The Cash Balance Approach or Cambridge Version.

However, we shall confine our discussion on the

most widely discussed version i.e. Fishers
Transaction version only.

The Transaction Approach or Fisher's Version

2.

This version explains that, other things remaining

unchanged, the changes in money supply bring about a
direct and proportionate change in the price level and
hence, an inversely proportionate change in the value of
money.
Assumptions:
The Price Level (P) is a Passive Factor
Total volume of transactions (T) remains unchanged.

3.

The velocity of circulation of money (V) remains constant

4.

The bank money is a function of lawful money.

1.

The Equation of exchange

MV = PT or, P = MV Where,
T
M' represents the quantity of money in circulation
'V' stands for the velocity of money in circulation
'P' is the general price level or average price per unit of 'T'
'T' represents the aggregate volume of transaction for which
money payments are made.
*The Equation states that P is directly related to MV and
inversely related to T.

The Equation of exchange

The Extended Form of the equation of
Exchange is :
MV+M'V' = PT
or, P = MV+M'V'
T
It is because in the modern economy money
includes not only notes and coins but bank's
demand deposits and credit money also.

CRITICAL EVALUATION OF THE TRANSACTION VERSION

1. The assumption that V,V' and T and the ratio between M and M'
are constant is highly unrealistic
In fact T changes with changes in technology, HYV etc. T may
be constant only in case of full employment which is not
attainable.
The inflation in Germany in 1923 was due to increase in V.
Because everybody tried to spend a rapidly depreciating Mark
as quickly as possible.
It is not proved that there is a proportional relationship between
M and M'. During Great Depression of the USA bank deposit
fell by 35% while currency outside bank rose by 30 %.

CRITICAL EVALUATION OF THE TRANSACTION VERSION

2. The

assumption that T and V are independent of

P and M is also not true. In fact all elements in
the equation is inter related.
3. The equation MV=PT does not show how and
why in fact money supply does changes and
how an increase and decrease in M reacts upon
P.
4. There is inconsistency like M refers to a point of
time, whereas V refers to the turnover of money
during a period of time.

CRITICAL EVALUATION OF THE TRANSACTION VERSION

5. The

assumption of Full Employment is

unrealistic in the sense that due to huge
unemployed resources in the economy every
increase in M would lead to an increase in real
income and output.
6. The theory does not throw light on national
income. T is the expenditure on both final and
intermediate transactions but national income
measures aggregate expenditure on final
products only.

CRITICAL EVALUATION OF THE TRANSACTION VERSION

7.

8.

9.

The theory is static in nature as it considers other

things remaining unchanged. It fact society is
dynamic.
It fails to explain the cyclical movements of prices
and production. The price level can not held stable
simply by making appropriate adjustment in
money supply. (Ex. Great Depression of the USA)
Price level does not entirely depend on factors
included in the equation. Due to human wants,
diversification industry, trade price .

CRITICAL EVALUATION OF THE TRANSACTION VERSION

10. The

theory overemphasizes the role of money

supply. Popuation price level
11. T represents commodity transactions only.
Commodity transaction is part of whole
transactions as there are financial, commercial
and industrial transactions.
12. The theory relates to money in circulation. But
people do keep some money as balance for
future .

The Quantity Theory vs. Income Theory

According to Quantity theory : Changes in the

quantity of money causes a change in the aggregate
demand for goods and services.
According to Income theory : Changes in the demand
for goods and services are results of changes in income
rather than money supply.
Example: If volume of expenditure of a community goes up
the income of the community also goes up As a result further
expansion of expenditures take place.
Consequently, the economy will expand and ultimately,
production, employment, trade as well as price level will rise.

Islamic view on value of money

1.
2.
3.

1.
2.

Islam consider value of money to be stable

It is the duty of the Islamic Govt. to do everything
possible to keep the value of money intact,
Islamic Govt. should not take any policy that may
cause the value of money eroded.
According to Islamic theory
the causes of distortion in the value of money are:
The existence of interest in the society
Reduction of production and trading activity

Islamic view on value of money

3. Expansion of credit by the banking system
4. Reckless use of credit instruments
5. Chief money policy of the govt.
6. increasing speculative demand for money
7. Expansionary monetary policy of the govt.