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What is meant by quantity theory of money?

QUANTITY THEORY OF MONEY
QUANTITY THEORY OF MONEY

Quantity theory of money explains that the value of money depends largely on the quantity of money. If the quantity of money is increased, without corresponding increase in volume of production, the value of money will decrease and vice-versa.

According to Irwing Fisher,

“Other things remaining the same, value of money fall in proportion to increase in quantity of money in circulation”.

It means it the quantity of money is increased by 25% whereas other things remain unchanged, the value of money will fall by 25%, and vice versa. Thus, the quantity of money and its value are inversely related.

Fisher explained the relationship between the quantity of money and its value in the form of equation of exchange.

P = MV + M’V’
____________
T

Where P stands for the general price level, T stands for total transactions (total amount of goods and services) exchanged, M stands for actual money, M’ stands for credit money, V stands for velocity (rate of exchanging hands) of actual money, V’ stands for velocity of credit money.

This is equal to the supply of money which consists of actual money (M) and credit money (M’) which their velocities (V + V’). For a numerical explanation of this equation of M is assumed 100, V equal to 5, V’ equal to 5 and T equal to 100 then
P = MV+M’V’   = 100 x 5 + 100 x 5 = 10
            T       100
In other words, the price of one unit of commodity will be Rs 10. If it is assumed that the quantity of M and M’ has been increased to double keeping V, V’ and T the same then:
                  200 x 5 + 200 x 5 = 20
                                                                                    100

The price has become double as compared to previous or the purchasing power of money has gone half because Rs. 10 Can purchases half of the commodity now.

Canons of Taxation or Principles of a good taxation System


CRITICISM ON THE THEORY

1. PRACTICALLY MISLEADING

The theory is theoretically convincing but practically is considered as a misleading one. In the real world, changes are frequently taking place. The very assumption in the theory that other things remaining the same are totally incorrect

2. PROPORTIONAL RELATIONSHIP DOES NOT EXIST

According to the theory, any increase or decrease in the quantity of money brings about a proportional change in the general price level. That is also no correct because prices of all the commodities do not change at the same rate even in the short period.

3. MONEY IS NOT ONLY A MEDIUM OF EXCHANGE

In Fisher’s theory, money has been taken only as a medium of exchange; that means it can only be used to exchange goods and services. That is also not true. Money maybe wanted for its own sake to be held as cash balances.

4. VARIABLES ARE NOT INDEPENDENT


Theory implies that M, V and T are independent variables. This is also against the reality. For, when there is a change in V (velocity) or in T (volume of goods and services) or in the both.

5. M AND V ARE DIFFERENT THINGS

M and v are two different things. Due to their difference, M is referred to as a point of time and V to a period of time. To multiply the both just considering them one is a wrong treatment.
MERITS OF THE THEORY

It helps us to understand the working of those main forces, which brings about fluctuations in the value of money.

This fact cannot b denied that whenever there has been over-issue of currency, price have gone up. The currency history of every country has examples in this regard.

The practical usefulness of the theory is evident from the fact that whenever the monetary authorities intend to prices they adopt the policy of regulating and controlling the issue of currency.

Friedman’s Restatement on the Quantity Theory of Money has been accepted by majority of the modern economists whose theories are also based on fisher’s Quantity Theory of Money.

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