Explain and critically evaluate the quantity theory of money. [12]
Classical and Monetarists are the main proponents of the quantity theory of money. The quantity theory of money assumed money only as a medium of exchange. Money facilitates the transactions. Unlike Keynesians, they believe money is not hoarded or held for speculative purposes. They argue that if the money supply rises faster than the rate of growth of national income, then there will be inflation. If the money supply increases in line with real output then there will be no inflation.
This can be shown in the equation as follows:
MV = PY (also known Fisher’s Equation)
where ;
M =money supply; it is assumed money has no effect on income, hence change in money supply will not change real GDP.
V = velocity of money; the average number of times a unit of money turns over or changes hands to effectuate transactions during a period of time.
P = price level;
Y = real GDP; is entirely determined by the fixed stock of labor, capital and technology.
MV = PY (also known Fisher’s Equation)
where ;
M =money supply; it is assumed money has no effect on income, hence change in money supply will not change real GDP.
V = velocity of money; the average number of times a unit of money turns over or changes hands to effectuate transactions during a period of time.
P = price level;
Y = real GDP; is entirely determined by the fixed stock of labor, capital and technology.
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). Monetarists assume that the short-term velocity (V) is fixed. This is because the rate at which money circulates is determined by institutional factors, e.g. how often workers are paid does not change very much. Milton Friedman admitted it might vary a little but not very much so it can be treated as fixed. 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.
The demand for money is equal to the total market value of all goods and services transacted. It is obtained by multiplying the total amount of goods produced (Y) by the average price level (P). Monetarists also believe output Y is fixed. They state it may vary in the short run but not in the long run since LRAS is inelastic and determined by supply-side factors.
Thus, the equation 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. Therefore, the classical quantity theory of money states that V and T being unchanged, changes in money cause direct and proportional changes in the price level. Therefore an increase in the money supply will lead to an increase in inflation.This theory can be illustrated using the AD and AS model. Suppose, there is an increase in money supply. Consumers have more money and therefore spend more money on goods; this shifts AD to the right from AD1 to AD2. Firms respond by increasing output along SRAS. Real output increases from Y1 to Y2. National output now exceeds the equilibrium level of output. Therefore there is an inflationary gap. Firms need to hire more workers, so wages rise leading to an increase in costs and hence prices. Initially, workers agree to work more hours because they see an increase in nominal wages. As prices rise money can buy less, therefore, there is a movement to the left along the new AD.
At the same time, workers realise the increase in nominal wage is not a real wage increase. Therefore, workers also demand higher nominal wages to produce more output and to compensate them for rising prices, therefore SRAS shifts to the left. Hence, the economy returns to the equilibrium level of output (Y1), but at a higher price level (P3). Therefore the rise in the money supply caused a rise in AD, but because the LRAS is inelastic there is no increase in real output, but inflation rises. It is a form of demand-pull inflation. Thus supporting the theory that as money supply increases, it would lead to an increase in price level (assuming V and Y remains constant). This reiterates that in the long-run there is no trade-off between inflation and unemployment. Increase in the money supply only causes an increase in nominal GDP, but not real GDP.
Based on the theory, the economists believe the role of monetary (or fiscal) policy is limited (Under the equilibrium conditions of full employment). However, during the temporary disequilibrium period of adjustment, an appropriate monetary policy can stabilise the economy by changing the supply of money. It can influence and control the price level and the level of economic activity of the country.
While the theory has its merits, it has also faced criticisms. Keynesians, for example, criticised this theory on several grounds. Firstly, he argues that an increase in money supply will not necessarily lead merely to rises in prices. If there is a lot of slack in the economy, with high unemployment, idle machines and idle resources, an increased spending of money may lead to substantial increases in real income (Y) and leave prices (P) little affected.
Additionally, if the government were to cut money supply in an attempt to reduce prices, the major effect might be to reduce output and employment instead. In terms of the quantity equation, a reduction in M may lead to a reduction in output and hence real income Y rather than a reduction in P.
Finally, the quantity theory maintains that price level is determined by the factors included in the equation of exchange, i.e. by M, V and Y. It establishes a direct and proportional relationship between the quantity of money and the price level. It ignores the importance of many other determinants of prices, such as income, expenditure, investment, saving, and consumption.