Page 108 - DECO402_Macro Economics

Unit-12: Demand of Money: Quantity Theory of Money

12.4 Quantity Theory of Money Notes

Quantity theory of money is the oldest theory of determining the value of money. It was demonstrated
in 1566 by the French economist, Jean Bodin. In 1588, Italian economist Davanzatti, in 1691british
economist John Locke and in 1752, David Hume made a much clearer description of this theory. In
twentieth century, this theory was described in detail by economists like, Irving fisher, Marshal, Pigou,
Robertson etc. Prof. Mition Friedman had presented the modern Quantity theory.
The Quantity Theory of Money states that there is a direct and proportionate relation between
quantity of money and general price-level and an inverse proportionate relation between quantity
of money and value of money. As per this theory, by an increase in quantity of money price level
increase in the same proportion and by a decrease in quantity of money, price level decreases in the
same proportion.
y As per J. S Mill, “The value of money, other things being the same, varies inversely with
its quantity; every increase of quantity lowers the value and every diminution raising it in
a ratio exactly equivalent.”
y In the words of Prof. A. C. L. Dey, “The quantity theory of money states that the price level
varies in direct proportion to the quantity of money. If the quantity of money doubles so
will be the price-level. Similarly, they will fall together.”
y In the words of Fisher, “Other things remaining unchanged, as the quantity of money in
circulation increases the price level increases in direct proportion and the value of money
decreases and vice versa”

Did You Know? Purchasing power of money is called the value of money

12.5 Two Equations of Quantity Theory of Money

Two main equations related to the theory of quantity of money are as follows:
1. Transactions Approach or Fisher’s Equation,
2. Cash Balance or Cambridge equation.

1. Transactions Approach or Fisher’s Equation

Prof. Irving Fisher, in his book “The purchasing power of money”, published in 1911 had demonstrated
the transaction approach of theory of quantity of money. As per Fisher, “The quantity theory is correct
in the sense that the level of prices varies directly with the quantity of money in circulation provided
the velocity of circulation of that money and volume of trade are not changed.” Which shows that value
of money (which is inverse of price level), changes inversely with the quantity of money. Generally,
Fisher’s theory of quantity of money is used in the form of below mentioned equation of exchange:

PY = MV + M 'V'
or
MV + M 'V'
P =
Y

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