MODULE THREE:

CHANGES IN THE
VALUE OF MONEY:
THE
QUANTITY THEORY
OF MONEY AND ITS
VARIANTS
Geoffrey ASIIMWE
 Unit One: Value Of Money

Unit Two: The Cambridge Equations:

The Cash Balance Approach

Unit Three: The Keynesian Theory

Agenda Of Money And Price

Unit Four: Friedman‘s Restatement of

Quantity Theory of Money and Supply
of Money
 UNIT ONE: VALUE OF MONEY
By value of money is meant the purchasing power of money over goods and
services in a country. What a Franc can buy in Rwanda represents the value of
money of the Rwanda Francs. However, the phrase, ‘value of money’ is a relative
concept which expresses the relationship between a unit of money and the goods
and services which can be purchased with it. This shows that the value of money
Click icon to add picture

is related to the price level because goods and services are purchased with a
money unit at given prices. But the relation between the value of money and
price level is an inverse one. If V presents the value of money and P the price
level, then, V = 1/P. When the price level rises, the value of money falls, and
vice versa. Thus, in order to measure the values of money, we have to find out the
general price level.

MONETARY POLICY & THEORY 3

 UNIT ONE: VALUE OF MONEY
The value of money is of two types, namely:
1. The internal value of money and
2. The external value of money.
Click icon to add picture

The internal value of money refers to the purchasing power of money over
domestic goods and services. The external value of money refers to the
purchasing power of money over foreign goods and service.

MONETARY POLICY & THEORY 4

 Fisher’s Quantity Theory of Money: The Cash
Transactions Approach
The quantity theory of money states that the quantity of money is the main
determinant of the price level or the value of money. Any change in the quantity
of money produces an exactly proportionate change in the price level.
In the words of Irving Fisher, “Other things remaining unchanged, as the
Click icon to add picture
quantity of money in circulation increases, the price level also increases in direct
proportion and the value of money decreases and vice versa.”
If the quantity of money is doubled, the price level will also double and the value
of money will be one half. On the other hand, if the quantity of money is reduced
by one half, the price level will also be reduced by one half and the value of
money will be twice.

MONETARY POLICY & THEORY 5

 Fisher’s Quantity Theory of Money: The Cash
Transactions Approach
Fisher has explained his theory in terms of his equation of exchange:
MV=PT
Where:
Click icon to add picture
•M represents the quantity of money in circulation (money supply)
•V represents the velocity of money (the rate at which money circulates in the
economy)
•P represents the price level (average price of goods and services in the economy)
•T represents the volume of transactions (the quantity of goods and services
exchanged)
MONETARY POLICY & THEORY 6
 Fisher’s Quantity Theory of Money: The Cash
Transactions Approach
Fisher’s Quantity theory of Money
Price level vs Money supply
When the quantity of money is doubled to
Click icon to add picture
M2, the price level is also doubled to P 2.
Further, when the quantity of money is
increased four-fold to M4, the price level
also increases by four times to P 4. This
relationship is expressed by the curve P = f
(M) from the origin at 45°.

MONETARY POLICY & THEORY 7

 Fisher’s Quantity Theory of Money: The Cash
Transactions Approach
Value of money vs Quantity of money
The inverse relation between the quantity of money
and the value of money is depicted where the value
of money is taken on the vertical axis. When the
quantity of money is M the value of moneyClick iconisto 1/P.
add picture

But with the doubling of the quantity of money to

M2, the value of money becomes one-half of what it
was before, 1/P2. And with the quantity of money
increasing by four-fold to M4, the value of money is
reduced by 1/P4. This inverse relationship between
the quantity of money and the value of money is
shown by downward sloping curve 1/P = f (M).

MONETARY POLICY & THEORY 8

 Fisher’s Quantity Theory of Money: The Cash
Transactions Approach
Let us give a numerical example.

Suppose the quantity of money (M) is Frw 5,000,000 in an

economy, the velocity of circulation of money (V) is 5; and the
total output to be transacted (T) is 2,500,000 units, the average
Click icon to add picture

price level (P) will be?

MONETARY POLICY & THEORY 9

 Fisher’s Quantity Theory of Money: The Cash
Transactions Approach
Let us give a numerical example.
Suppose the quantity of money (M) is Frw 5,000,000 in an economy, the velocity of circulation
of money (V) is 5; and the total output to be transacted (T) is 2,500,000 units, the average price
level (P) will be:
Click icon to add picture
P = MV/T
= 5, 000,000 × 5/ 2,500,000 = 2,500,000/ 2,500,000
= Frw 10 per unit.
If now, other things remaining the same, the quantity of money is doubled, i.e., increased to Frw
10,000,000 then:
P = 10,000,000 × 5/ 2,500,000 = Frw20 per unit

MONETARY POLICY & THEORY 10

 Fisher’s Quantity Theory of Money: The Cash
Transactions Approach
We thus see that according to the quantity theory of money, price level
varies in direct proportion to the quantity of money. A doubling of the
quantity of money (M) will lead to the doubling of the price level.
Further, since changes in theClickquantity of money are assumed to be
icon to add picture

independent or autonomous of the price level, the changes in the

quantity of money become the cause of the changes in the price level.

MONETARY POLICY & THEORY 11

 Quantity Theory of Money: Income Version:
Fisher‘s transactions approach to quantity theory of money described in equation
(1) and (2) above considers such variables as total volume of transaction (T) and
average price level of these transactions are conceptually vague and difficult to
measure.
Click icon to add picture
Therefore, in later years quantity theory was formulated in income from which
considers real income or national output (i.e., transactions of final goods only)
rather than all transactions. As the data regarding national income or output is
readily available, the income version of the quantity theory is being increasingly
used.
Moreover, the average price level of output is a more meaningful and useful
concept.
MONETARY POLICY & THEORY 12
 Quantity Theory of Money: Income Version:
Indeed, in actual practice, the general price level in a country is measured taking into
account only the prices of final goods and services which constitute national product.
It may be noted that even in this income version of the quantity theory of money, the
function of money is considered to be a means of exchange as in the transactions
Click icon to add picture
approach of Fisher.
In this approach, the concept of income velocity of money has been used instead of
transactions velocity of circulation.
By income velocity we mean the average number of times per period a unit of
money is used in making payments involving final goods and services, that is,
national product or national income. In fact, income velocity of money is measured by
Y/M where Y stands for real national income and M for the quantity of money.
MONETARY POLICY & THEORY 13
 Quantity Theory of Money: Income Version:
Therefore, The Quantity Theory of Money in its income version is a macroeconomic theory
that explores the relationship between the quantity of money in an economy, the overall price
level, and the level of real income or output. It's an important concept in monetary economics
that helps in understanding the factors that influence inflation and economic growth. The
income version of the Quantity Theory of Money is often expressed using the equation:
Click icon to add picture
MV=PY
Where:
•M represents the quantity of money in circulation (money supply)
•V represents the income velocity of circulation (the rate at which money circulates in the economy)
•P represents the price level (average price of goods and services in the economy)
•Y represents the real output or real income in the economy

MONETARY POLICY & THEORY 14

 Quantity Theory of Money: Income Version:
Like that in the transactions approach, in this new income version of the quantity
theory also the different variables are assumed to be independent of each other.
Further, income velocity of money (V) and real income or aggregate output (Y) is
assumed to be given and constant during a short period.
Click icon to add picture
More specifically, they do not vary in response to the changes in M. In fact, real
income or output (Y) is assumed to be determined by the real sector forces such as
capital stock, the amount and skills of labour, technology etc. But as these factors
are taken to be given and constant in the short-run and further full employment of
the given resources is assumed to be prevailing due to the operation of Say‘s law
and wage-price flexibility supply of output is taken to be inelastic and constant for
purposes of determination of price level.
MONETARY POLICY & THEORY 15
 Quantity Theory of Money: Income Version:
Classical quantity theory of money is illustrated in below through
aggregate demand and aggregate supply model. It is worth noting that
the quantity of money (M) multiplied by the income velocity of
circulation (V), that is, MVClickgives us
icon to add aggregate expenditure in the
picture

quantity theory of money. Now with a given quantity of money, say

M1 and constant velocity of money V, we have a given amount of
monetary expenditure (M1 V).

MONETARY POLICY & THEORY 16

 Quantity Theory of Money: Income Version:
Given this aggregate expenditure, at a lower price level more quantities of goods can
be purchased and at a higher price level, less quantities of goods can be purchased.
Therefore, in accordance with classical quantity theory of money, aggregate demand
representing M1 slopes downward as shown by the aggregate demand curve AD 1. If
now the quantity of money is increased, say to M 2, aggregate demand curve
representing new aggregate monetary expenditure M 2 V will shift upward.
As regards, aggregate supply curve, due to the assumption
Clickof wage-price
icon flexibility, it
to add picture
is perfectly inelastic at full-employment level of output as is shown by the vertical
aggregate supply curve AS in the graph. Now, with a given quantity of money equal
to M1, aggregate demand curve AD1 cuts the aggregate supply curve AS at point E
and determines price level OP1.
Now, if the quantity of money is increased to M 2, the aggregate demand curve shifts
upward to AD2. It will be seen from Fig. 20.1 that with the increase in aggregate
demand to AD2 consequent to the expansion in money supply to M 2, excess demand
equal to EB emerges at the current price level OP 1. This excess demand for goods
and services will lead to the rise in price level to OP 2 at which again aggregate
quantity demanded equals the aggregate supply which remains unchanged at OY due
to the existence of full employment in the economy.
MONETARY POLICY & THEORY 17
 Assumptions of the Theory:
Fisher‘s theory is based on the following assumptions:
1.Stability/Constant of Velocity of Money (V):
Fisher assumed that the velocity of money (V), which represents the rate at which money
circulates in the economy, remains relatively stable over time. In other words, the average
Click icon to add picture
number of times a unit of money is used to make transactions is assumed to be constant. This
assumption allows for a straightforward relationship between the money supply and nominal
GDP or the price level.
2. Stable/Constant Real Output (Y):
Another assumption is that the real output of goods and services (Y) in the economy remains
constant or grows at a stable rate. This assumption suggests that the economy operates at its
full potential, and the quantity of goods and services produced (the real output) is not subject
to significant short-term fluctuations.
MONETARY POLICY & THEORY 18
 Assumptions of the Theory:
3. Full Employment of Resources:
The theory assumes that the economy is operating at full employment or near its
potential output level (Y). This implies that the resources in the economy (labor,
capital, etc.) are fully utilized, Click
andicon any increase in the money supply will
to add picture
primarily drive up prices rather than increase output.
4. Monetary Neutrality:
Fisher's theory assumes that changes in the money supply (M) have no impact on
real variables in the economy, such as the real output (Y) and the employment
level. Monetary neutrality suggests that alterations in the money supply only
affect nominal variables, like price levels (P) and nominal income (MV).
MONETARY POLICY & THEORY 19
 Criticisms of Fisher’s Theory:
The Quantity Theory of Money has been subject to various criticisms over the years, as it is a simplified model that
doesn't always capture the complexities of real-world monetary and economic systems. Here are some of the main
criticisms of the Quantity Theory of Money:
1. Velocity Assumption:
The theory assumes that the velocity of money (V) is stable over time. In reality, velocity can fluctuate due to
changes in economic conditions, financial innovations,
Click iconand consumer
to add picture behavior. This assumption oversimplifies the
relationship between money and economic activity.
2. Real Output Assumption:
The theory assumes that real output (Y) remains constant in the short run. In reality, changes in money supply can
influence real output, especially in the long run, through investments, production, and employment. This assumption
neglects the potential impact of monetary policy on output.
3. Monetary Neutrality:
Critics argue that the assumption of monetary neutrality, which implies that changes in the money supply have no
real effects on the economy, is too simplistic. In the real world, monetary policy can impact interest rates,
investment decisions, and real economic activity.
MONETARY POLICY & THEORY 20
 Criticisms of Fisher’s Theory:
4. Inadequate Consideration of Expectations:
The theory assumes that economic agents have rational expectations and instantly adjust their behavior in response
to changes in the money supply. In reality, expectations can be influenced by a wide range of factors, and
adjustments may not be immediate or efficient.
5. Limited Application to Modern Banking Systems:
The original Quantity Theory focused on a narrow
Clickdefinition
icon to add of money as currency and demand deposits. It doesn't
picture
account for the broader monetary aggregates and the role of financial institutions and credit creation in the modern
banking system.
6. Assumption of Full Employment:
The theory assumes full employment of resources, which is often not the case in real economies. Changes in the
money supply may have different effects during periods of high unemployment or underutilized resources.
7. Role of Fiscal Policy:
The Quantity Theory primarily focuses on monetary policy but doesn't consider the interactions with fiscal policy
(government spending and taxation). In practice, fiscal and monetary policies often work in conjunction, affecting
economic outcomes.
MONETARY POLICY & THEORY 21
 CONCLUSION
The quantity theory of money is the idea that the supply of money in an economy
determines the level of prices and changes in the money supply result in
proportional changes in prices. In other words, the quantity theory of money states
that a given percentage changes in the money supply results in an equivalent level
Click icon to add picture
of inflation or deflation. This concept is usually introduced via an equation relating
money and prices to other economic variables.

MONETARY POLICY & THEORY 22

 Self assessment exercise
Discuss in detail the quantity theory of money

Explain and analyze the fisher‘s equation

Click icon to add picture of money

MONETARY POLICY & THEORY 23

 Self assessment exercise
1. According to the Quantity Theory of Money, the value of money depends upon
(a) Quantity of money in circulation
(b) Purchasing power of money
(c) Demand for money
(d) Price level
2. The degree of relationship between the demand for Click iconthe
and to add picture
supply of money in Fisher’s equation will be
(a) 𝑠𝑢𝑝𝑝𝑙𝑦 > 𝑑𝑒𝑚𝑎𝑛𝑑
(b) 𝑠𝑢𝑝𝑝𝑙𝑦 =𝑑𝑒𝑚𝑎𝑛𝑑
(c) 𝑠𝑢𝑝𝑝𝑙𝑦 < 𝑑𝑒𝑚𝑎𝑛𝑑
(d) None of the above
3. Which of the following is a qualitative or selective method of credit control by the central bank?
(a) Bank rate or Discount Rate Policy
(b) Open market operations
(c) Cash Reserve Ratio
(d) None of the above
MONETARY POLICY & THEORY 24
 UNIT TWO: THE CAMBRIDGE EQUATIONS:
THE CASH BALANCE APPROACH
The Cambridge equation formally represents the Cambridge cash-balance
theory, an alternative approach to the classical quantity theory of money.
Both quantity theories, Cambridge and classical, attempt to express a
relationship among the amount ofClickgoods produced, the price level, amounts of
icon to add picture
money, and how money moves. The Cambridge equation focuses on money
demand instead of money supply. The theories also differ in explaining the
movement of money:
In the classical version, associated with Irving Fisher, money moves at a fixed
rate and serves only as a medium of exchange while in the Cambridge approach
money acts as a store of value and its movement depends on the desirability of
holding cash.
MONETARY POLICY & THEORY 25
 UNIT TWO: THE CAMBRIDGE EQUATIONS:
THE CASH BALANCE APPROACH
The approach was developed by economists at the University of Cambridge in the
early 20th century, notably John Maynard Keynes, Alfred Marshall, and A.C.
Pigou.
Click icon to add picture
The fundamental idea behind the Cambridge Equations is to explain the demand
for money in terms of the factors that influence individuals' and businesses'
decisions regarding how much cash to hold. The main focus is on the demand for
money as a store of value and its relationship with interest rates.

There are two main Cambridge Equations: the Transactions Demand for Money
and the Portfolio Demand for Money.
MONETARY POLICY & THEORY 26
 UNIT TWO: THE CAMBRIDGE EQUATIONS:
THE CASH BALANCE APPROACH
1. Transactions Demand for Money: The transactions demand for money refers to the need for
individuals and businesses to hold cash for their day-to-day transactions. According to the Cambridge
Equations, this demand for money is influenced by the level of income and the velocity of money (the
rate at which money is exchanged in the economy for goods and services). Mathematically, the
equation is often represented as:
Click icon to add picture
M =k⋅PY Where:
T

•MT is the transactions demand for money

•k is the proportion of income held as cash
•P is the price level
•Y is the real income
The equation suggests that the demand for money for transactions (MT) is directly proportional to the
level of income (Y) and the price level (P), with k as the proportionality
MONETARY POLICY & THEORY 27
 UNIT TWO: THE CAMBRIDGE EQUATIONS:
THE CASH BALANCE APPROACH
2. Portfolio Demand for Money: The portfolio demand for money focuses on the role of money as an asset and
how individuals choose to allocate their wealth between cash and interest-bearing assets like bonds. According to
this approach, individuals decide how much money to hold in their portfolios based on the expected return on
money (which is the nominal interest rate) and the expected return on bonds (which is the real interest rate adjusted
for inflation).
MP=L(i,r) Where: Click icon to add picture

•MP is the portfolio demand for money

•L is a function representing the liquidity preference (demand for money)
•i is the nominal interest rate
•r is the real interest rate
This equation suggests that the portfolio demand for money (MP) is influenced by the nominal interest rate (i) and
the real interest rate (r), with individuals seeking to balance the opportunity cost of holding money (foregoing
interest) with the benefits of liquidity.
MONETARY POLICY & THEORY 28
 UNIT TWO: THE CAMBRIDGE EQUATIONS:
THE CASH BALANCE APPROACH
The Cambridge Equations provide a framework for understanding how individuals
and firms determine their demand for money based on their economic
circumstances and preferences. They have been influential in shaping modern
monetary theory and policy, particularly in understanding the relationship between
money demand, interest rates, and Click icon to add picture
macroeconomic variables.

MONETARY POLICY & THEORY 29

 CONCLUSION
The Cambridge equation formally represents the Cambridge cash-balance theory,
an alternative approach to the classical quantity theory of money. Both quantity
theories, Cambridge and classical, attempt to express a relationship among the
amount of goods produced, the price level, amounts of money, and how money
moves. The Cambridge equation Click icon to add picture
focuses on money demand instead of money
supply. The theories also differ in explaining the movement of money: In the
classical version, associated with Irving Fisher, money moves at a fixed rate and
serves only as a medium of exchange while in the Cambridge approach money
acts as a store of value and its movement depends on the desirability of holding
cash.

MONETARY POLICY & THEORY 30

 Self Assessment exercise

Discuss in detail the debate between the Cambridge equation of cash balances
Approach and the quantity theory of money.
Click icon to add picture

MONETARY POLICY & THEORY 31

 UNIT THREE: THE KEYNESIAN THEORY OF
MONEY AND PRICE CONTENTS
Keynes, a prominent economist of the 20th century, offered a reformulated perspective on the
Quantity Theory of Money that diverged from traditional views. Keynesian economics challenged
classical notions that money supply directly determines the price level in the economy. Keynes
argued that various factors, particularly aggregate demand and expectations, play a significant role
in shaping the economy's price level and output. The Keynesian reformulated quantity theory of
Click icon to add picture
money is based on the following:
Assumptions:
1. All factors of production are in perfectly elastic supply so long as there is any unemployment.
2. All unemployed factors are homogeneous (a production function is said to be homogeneous of
degree n if when each input is multiplied by some number t, output increases by the factor tn),
perfectly divisible and interchangeable.
3. There are constant returns to scale so that prices do not rise or fall as output increases. of money
change in the same proportion so long as there are any unemployed resources.
MONETARY POLICY & THEORY 32
 UNIT THREE: THE KEYNESIAN THEORY OF
MONEY AND PRICE CONTENTS
Given these assumptions, the Keynesian chain of causation between changes in the
quantity of money and in prices is an indirect one through the rate of interest. So
when the quantity of money is increased, its first impact is on the rate of interest
which tends to fall. Given the marginal efficiency of capita, a fall in the rate of
interest will increase the volume ofClick icon to add picture
investment.
The increased investment will raise effective demand through the multiplier effect
thereby increasing income, output and employment. Since the supply curve of
factors of production is perfectly elastic in a situation of unemployment, wage and
non-wage factors are available at constant rate of remuneration. There being
constant returns to scale, prices do not rise with the increase in output so long as
there is any unemployment.
MONETARY POLICY & THEORY 33
 UNIT THREE: THE KEYNESIAN THEORY OF
MONEY AND PRICE CONTENTS
Under the circumstances, output and employment will increase in the same proportion as
effective demand, and the effective demand will increase in the same proportion as the quantity
of money. But once full employment is reached, output ceases to respond at all to changes in the
supply of money and so in effective demand. The elasticity of supply of output in response to
changes in the supply, which was infinite as long as there was unemployment falls to zero. The
Click icon to add picture
entire effect of changes in the supply of money is exerted on prices, which rise in exact
proportion with the increase in effective demand.
Thus so long as there is unemployment, output will change in the same proportion as the
quantity of money, and there will be no change in prices; and when there is full employment,
prices will change in the same proportion as the quantity of money. Therefore, the reformulated
quantity theory of money stresses the point that with increase in the quantity of money prices
rise only when the level of full employment is reached, and not before this.

MONETARY POLICY & THEORY 34

 Criticisms of Keynes Theory of Money and
Prices:
Keynes‘ views on money and prices have been criticized by the monetarists on the following
grounds.
1. Direct Relation:
Keynes mistakenly took prices as fixed so that the effect of money appears in his analysis in
terms of quantity of goods traded rather Click
than icon to add picture
their average prices. That is why Keynes adopted
an indirect mechanism through bond prices, interest rates and investment of the effects of
monetary changes on economic activity. But the actual effects of monetary changes are direct
rather than indirect.
2. Stable Demand for Money:
Keynes assumed that monetary changes were largely absorbed by changes in the demand for
money. But Friedman has shown on the basis of his empirical studies that the demand for
money is highly stable.
MONETARY POLICY & THEORY 35
 Criticisms of Keynes Theory of Money and
Prices:
3. Nature of Money:
Keynes failed to understand the true nature of money. He believed that money
could be exchanged for bonds only. In fact, money can be exchanged for many
different types of assets like bonds,Click
securities, physical assets, human wealth, etc.
icon to add picture

4. Effect of Money:
Since Keynes wrote for a depression period, this led him to conclude that money
had little effect on income. According to Friedman, it was the contraction of
money that precipitated the depression. It was, therefore, wrong on the part of
Keynes to argue that money had little effect on income. Money does affect
national income.
MONETARY POLICY & THEORY 36
 CONCLUSION
In this unit, we can conclude that the quantity theory of money (QTM) states that
money supply has a direct, proportional relationship with the price level. For
example, if the currency in circulation increased, there would be a proportional
increase in the price of goods. The theory was challenged by Keynesian
economics, but updated and reinvigorated by the monetarist school of economics.
Click icon to add picture

While mainstream economists agree that the quantity theory holds true in the
long-run, there is still disagreement about its applicability in the short-run. Critics
of the theory argue that money velocity is not stable and, in the short-run, prices
are sticky, so the direct relationship between money supply and price level does
not hold. Alternative theories include the real bills doctrine and the more recent
fiscal theory of the price level.

MONETARY POLICY & THEORY 37

 Self-Assessment Exercise
List and explain the criticism of Keynes theory of money and prices

Click icon to add picture

MONETARY POLICY & THEORY 38

 UNIT FOUR: FRIEDMAN’S RESTATEMENT OF QUANTITY
THEORY OF MONEY AND SUPPLY OF MONEY
Milton Friedman, a prominent economist and Nobel laureate, is well-known for his restatement and
popularization of the Quantity Theory of Money. His version, often referred to as the "Monetarist
Quantity Theory of Money," provided a modern reinterpretation of the classical quantity theory,
focusing on the relationship between the money supply and nominal income.
1. Equation of Exchange: Friedman's formulation is often expressed through the Equation of
Click icon to add picture
Exchange, which relates the money supply (M), the velocity of money (V), the price level (P), and
the level of real output (Y):
MV=PY
•M represents the money supply.
•V represents the velocity of money (how quickly money circulates in the economy).
•P represents the price level.
•Y represents the real output.
MONETARY POLICY & THEORY 39
 UNIT FOUR: FRIEDMAN’S RESTATEMENT OF QUANTITY
THEORY OF MONEY AND SUPPLY OF MONEY
2. Money Demand: Friedman acknowledged that the demand for money is influenced by
several factors, including income, interest rates, and transactional needs. He argued that
people hold money for transactions (transactions demand) and as a store of value (asset
demand). The total demand for money is the sum of these demands.
Click icon to add
3. Quantity Theory and Inflation: Friedman picture
emphasized that in the long run, changes in
the money supply primarily affect the price level, not real output. An increase in the
money supply leads to a proportional increase in prices (inflation), assuming velocity and
real output remain stable.
4. Monetary Neutrality: Friedman believed in the concept of "monetary neutrality,"
suggesting that changes in the money supply do not have a lasting impact on real
variables such as output, employment, or economic growth in the long run. Money is seen
as a neutral factor affecting only nominal
MONETARY POLICY & THEORY 40
 Criticisms of Friedman's Monetarist Quantity Theory of Money

1. Velocity Assumption and Stability:

Friedman's theory assumes that the velocity of money is relatively stable over time.
However, empirical evidence suggests that velocity can be quite volatile and is not
constant. Changes in financial innovations, payment technologies, and consumer
Click icon to add picture
behavior can alter the velocity of money, challenging the stability assumption.
2. Assumption of Full Employment:
The theory assumes that the economy is at or near full employment in the long run.
However, this assumption may not hold in the real world, especially during periods
of economic downturns or structural imbalances. In such scenarios, changes in the
money supply may not only affect prices but also real output and employment.

MONETARY POLICY & THEORY 41

 Criticisms of Friedman's Monetarist Quantity Theory of Money

3. Real vs. Nominal Variables:

Critics argue that Friedman's theory focuses too much on nominal variables like
the price level and nominal income, neglecting the analysis of real variables such
as real GDP, productivity, and standard of living. Ignoring real variables may
Click icon to add picture
oversimplify the relationship between the money supply and the overall economy.
4. Inadequate Treatment of Expectations:
The theory does not fully consider the role of expectations in shaping the behavior
of economic agents. Changes in expectations about future monetary policy or
economic conditions can significantly impact the effectiveness of monetary
measures and alter the outcomes predicted by the theory.
MONETARY POLICY & THEORY 42
 CONCLUSION
In this unit, we conclude that Milton Friedman improved on Keynes‘s liquidity
preference theory by treating money like any other asset. He concluded that
economic agents (individuals, firms, governments) want to hold a certain
quantity of real, as opposed to nominal, money balances. If inflation erodes the
purchasing power of the unit of Click
account, economic agents will want to hold
icon to add picture

higher nominal balances to compensate, to keep their real money balances

constant. The level of those real balances, Friedman argued, was a function of
permanent income (the present discounted value of all expected future income),
the relative expected return on bonds and stocks versus money, and expected
inflation.

MONETARY POLICY & THEORY 43

 Self-Assessment Exercise

Discuss the Friedman‘s quantity theory of money and its

criticisms

Click icon to add picture

MONETARY POLICY & THEORY 44