Question

Explain how the two formulation of the quantity theory are formally equivalent. Why cambridge equation is considered to be more close to the modern theory.

Answer 1

Fishers transaction approach

Fisher in his quantity theory of money states that increase in general price level is caused by increase in quantity of money and vise versa. Three factors that influence general price level in the economy are

a) volume of trade - quantity of goods and services being exchanged in the economy.

b) velocity of money circulation - number of times a unit of currency is used for transaction

c) quantity of money circulation - currency, notes, demand deposits in banks.

Fishers equation

PT = MV

P = MV/T

T - total amount of goods and services transacted

P - average price level in the economy

M - quantity of money

V - velocity of money circulation.

Fisher assumes that T and V is constant. M is determined by the government and central bank. Since T and V are constants, a changes in rice level is caused by change in money supply as seen in the above equations.

Cambridge version of quantity theory of money

Value of money or purchasing power of money is determined by the demand and supply of money. The equation can be written as

Md = kPY where

Md - amount of money people want to hold

Y - output

P - price level PY - nominal national income

k - proportion of nominal national income people want to hold in money

To be in equilibrium demand and supply of money must be equal. Supply of money is determined by the central bank and government.

In the figure initial equilibrium is at E0, where price level is P0 and quantity of money is M0. Suppose money supply increases to M1. At P0 price level people will be more money than they demand. So they increases their expenditure which leads to increase in price level. As price increase people would demand more money. The equilibrium is at E1 where the price level is P1 and quantity of money demanded and supplied is M1.

k in the equation is related to velocity of money in fisher equation. Thus when people keep more proportion money in with then, value of V falls.

Cambridge economist also assumes that both k and Y remains constant. Thus changes in price level is caused by changes in quantity of money.

Here we can see that both equations are similar in nature and both convey the effects of changes in quantity of money on general price level.

Why is Cambridge equation considered to be modern theory?

Fishers equation is based on medium of exchange of money function. Cash balance approach is based on store of value function of money.

Velocity of money circulation, in transaction approach deals with mechanical aspects of payments where as cash balance approach deals with behavioural aspects.

Cash balance approach states how value of money is determined using demand and supply of money.

To conclude cash balance approach is an improvement over Fishers equation.