The Quantity Theory of Money
The quantity theory of money
The quantity theory of money seeks to explain the value of money in terms of changes in its quantity. Stated in its simplest form, the quantity theory of money says that the value of money varies inversely as its quantity. "Double the quantity of money, and other things being equal, prices will be twice as high as before, and the value of money one-half. Halve the quantity of money and, other things being equal, prices will be one-half of what they were before and the value of money double." The theory can also be stated in these words: The value of money falls (and the price level rises) proportionately with a given increase in the quantity of money. Conversely, the value of money rises (and the price level falls) proportionately with a given decrease in the quantity of money, other things remaining the same.
There are several forces that determine the value of money and the general price level. The general price level in a community is influenced by the following factors: —
(a) the volume of trade,
(b) the quantities of currency, )
(c) the volume of credit, and
(d) The velocity (or rapidity) of circulation of currency.
These four factors change independently as well as in relation to each other.
Money is used in exchanging goods. The greater the volume of exchange required to be made, the greater is the demand for money and hence the greater will be the value of one unit of money, and vice versa. Thus, the value of money varies directly with the volume of trade.
It is well-known that the value of anything depends on its supply. The more the wheat in a season, the less its price. In the same way, the greater the number of rupees to do a given amount of money work, the less is the value of a rupee, and vice versa. In other words, the value of a unit of money varies inversely with its quantity.
But, we have learnt that all the money-work is not performed by cash-money. A good deal of it is also done by credit money. Hence, credit instruments should also be taken into consideration when we are trying to discover the total quantity of money which will influence prices in a country.
Also, it is to be remembered that money is not finished up in one use. A unit of money is ready to perform another exchange after it has served in making one. It passes from hand to hand. Thus, if a single rupee is used six times in a certain period, it does the work of six rupees, if they serve only once each in the same period. Hence, the number of times a rupee changes hands in, say, a year, it is known as its "velocity of circulation''. Thus, the velocity of circulation of money helps the total quantity of money in determining prices.
The above conclusions have been put in the form of a theory called the Quantity Theory of Money. It declares that the value of money depends upon its quantity in circulation. In its most rigid form, this theory asserts that "any given percentage increase or decrease in the quantity of money will lead to the same percentage of increase or decrease in the general level of prices."
In order to make it applicable to a modern community, the theory may be stated thus: The value of money falls (and the price level rises) proportionately with a given increase in the quantity of money. Conversely, the value of money rises (and the price level falls) proportionately with a given decrease in the quantity of money, other things remaining the same.
These other things are:
(a) velocity of circulation of money;
(b) the volume of credit;
(c) barter; and
(d) volume of trade.
Money, we know, is only a medium of exchange. It is only a counter or a ticket serving as a link in exchange and is not wanted for its own sake. Therefore, the quantity theory concludes that if a community had twice as much money, all prices would be twice as high and if it has half as much money, all prices would be half as high. The total purchasing power of all money would always be the same because "money is only important for what it will procure."(Keynes).
Quantity Theory of Money example
If in an island, one hundred articles of equal value are available for sale and there are two hundred units of money, the average price would be two units of money per article. If one fine morning, every one woke up to find that the money with him had doubled itself, the average price would become four units per article. And if the money possessed by-everybody were halved, no one would be the poorer for it, because now every coin would begin to purchase twice as much as before. In other words, the elasticity of demand for money is unity. ?
Extending the general theory of value to money, we can say that if the quantity of money in circulation were increased with no change in the number of goods its value would fall and prices rise, and vice versa.
Similarly, an increase in the amount of goods without a change in the quantity of money will tend to raise the value of money and lower prices, and vice versa.
It should be noted that a change in the supply of goods does not cause a proportionate change in their value. But the change in the value of money is proportionate to change in its quantity.