MONETORY THEORIES

Quantity Theory of Money

 Theory of how nominal value of aggregate income is determined.
 Theory of the demand of money
 Suggests that interest rates have no effect on the demand of money

The relationship between Money and Interest Rate in the Classical Model
 Money is used for transactionary purposes only.
 Money has no effect on the real interest rate but on the general price level only.
 Money will effect prices
Irving Fisher’s Quantity Theory Of Money Demand

Velocity of Money & Equation Of Exchange

 Irving Fisher wanted to examine the link between the total quantity of money M ( the money
supply ) and the total amount of spending on final goods and services produced in the economy
P x Y , where :
P = the price level
Y = aggregate output ( income )
 The link between M and P x Y is called velocity of money, the rate of turnover of money, that is,
the average number of times per year that a Ringgit spent in buying the total amount of goods
and services produced in the economy.
 Velocity is defined more precisely as total spending:
V=PxY
M
 By multiplying both sides of the definition by M, we obtain the equation of exchange, which
relates nominal income to the quantity of money and velocity :
MxV=PxY
 The equation of exchange thus states that nominal income must be equal to the quantity of
money multiplied by the velocity.
 Fisher said that velocity is determined by the institutions in an economy that effect the way
individuals conduct transactions.
Quantity Theory

 Fisher’s view that velocity is fairly constant in the short run transforms the equation of exchange
into the quantiy theory of money. When the quantity of money M doubles, M x V doubles and so
must P x Y, the value of nominal income.
 The quantity of money then implies that if M doubles, P must also be doubled in the short run
because V and Y are constant.
 For the classical economist, the quantity theory of money provided an explanation of movements
in the price level: Movements in the price level result solely from changes in the quantity of
money.