Quantity theory of money

Fishers – 1st transaction approach

Cambridge cash balance approach

Compare fisher’s equation and Keynes Cambridge equation

Similarities

Differences

Explain why Cambridge function is more comprehensive

The Classical Quantity Theory of Money

[edit] History

This theory was described comprehensively by Irving Fisher (1911), in the book The
Purchasing Power of Money. It is the classical view of how money is used in the economy,
and what variables it affects.

[edit] Fisher's Model

Consider a closed economy. In every transaction, the value of sales and the value of
purchases must match. Therefore, even when scaled up to the aggregate level, the value of
payments must equal the value of receipts.

But Pt, the value of payments, must be equal to the number of transactions multiplied by the
average price they take place at. R, the value of receipts, must be equal to the amount of
money in the economy multipled by the average number of times it circulates (or, the velocity
of money).

This gives us an identity:

where P is simply the price level and T is the volume of transactions. Ms is the supply of
money in the economy, and VT is termed the velocity of transaction.

[edit] An Evaluation
[edit] Inflation

Consider now the behaviour of these variables in the real world. The money supply is of
course exogenously determined (by the government / central bank). We can assume that in
equilibrium the market clears and therefore the supply of money Ms is equal to the demand
for money Md.

Fisher further assumed that the volume of transactions T would be relatively stable at long
run equilibrium, and that the velocity of money VT would also be invariant in the short run.
This would then give us the following equation:

It can be seen that any change to the price level is wholly induced by changes to the
exogenous variables. If we consider VT and T invariant over the short run, the rate of change
in P is entirely due to the rate of change in Md. That is, the rate of inflation in the economy is
entirely due to changes in the money supply. The equilibriating mechanism is the change in
money demand.

[edit] The Neutrality of Money

Consider the basic equation of the model.

We then have:

If the Fisherian quantity theory is correct, then any change in Md would lead to a
corresponding change in P, while the real variables, T and VT, remain unchanged. This is
known as the neutrality of money, a condition whereby changes to the money supply affect
only nominal variables. A related, and harder condition to satisfy, is the superneutrality of
money, where changes in the rate of growth of the nominal money supply influence only the
rate of inflation, and the rate of depreciation of the currency in an open economy. There is no
effect on any other variable.
[edit] Marshall, Pigou and Keynes - Developments of the
Classical Theory
[edit] History

This preliminary version of the quantity theory was developed by Marshall and Pigou (1917)
in order to extend the analysis to consider short run fluctuations in the velocity of money. In
Fisherian quantity theory the velocity of money was determined exogenously.

[edit] A change in viewpoint

Under the Fisherian analysis an individual holds as much money as he needs in order to carry
out transactions. Marshall and Pigou approached the problem slightly differently. Their
version of the quantity theory determines how much money an individual chooses to hold in
order to carry out transactions.

The explicit assumptions here are that the individual cannot hold more money than his stock
of wealth, that he makes a choice between money, which does not pay interest income, and
bonds, which do. The demand for money function therefore varies with the interest rate, the
level of wealth, and the volume of transactions that said individual wishes to carry out.

The model proposed by Marshall and Pigou was simplified by assuming that the volume of
transactions would be stable in the short run. This allowed the aggregate real money demand
function to be equated to some proportion of the level of real income in the economy. We
thus have:

Rearranging:

And:

Here, the constant k - 1 is the income velocity of money, as opposed to in the Fisherian
analysis, which was the transactions velocity of money.

[edit] Keynesian analysis - the introduction of the interest rate

Keynes' contribution to the above analysis focused on defining more clearly the motives
economic agents had in holding money. He defined 3 motives for holding money - the
transactions motive (where agents hold money in order to make planned payments), the
precautionary motive (where agents hold money against the unforeseen need to make
payments) and the speculative motive (where agents make the decision to hold money
according to the opportunity cost of doing so).

The speculative motive can be explained more clearly by considering the asset allocation
decision between money and bonds. We defined bonds earlier as any asset that pays an
income. The rate of this income is, quite clearly, the interest rate. If the interest rate is
expected to fall, the price of bonds will rise, and if the interest rate is expected to rise, the
price of bonds will fall.

Keynes extended the analysis by assuming that there is a range of interest rates that is
considered to be the mean range, and that the interest rate would be mean-reverting towards
it.