Explain and critically evaluate the quantity theory of money. [12]
The quantity theory of money is a theory that states that in ation is linked to changes in
the money supply. Classical economists adhere to this theory. In ation occurs when the
money supply is increasing at a persistent rate greater than that of output within an
economy. The Fisher Equation operationalises this concept into the following equation:
MV = PY. M is the money supply, V is the velocity of circulation, P is the price level, and Y
is the output in the economy. Classicists state that both V and Y are constant, or at least
stable, and thus a direct link is provided between M and P, the money supply and price
level.
For example, say that the money supply is $80 billion, velocity is 5, price level is 100, and
output is $4 billion. The equation is correct: $80B x 5 = 100 x $4B, or $400B = $400B.
Now say that the money supply increase 50% to 120. Assuming that V and Y are
constant, the price level with also rise by 50% to 150.
Therefore, classicists view in ation as a monetary phenomenon. However, Keynesians
disagree with this. They argue that V and Y are not constant and can change with the
money supply as well, disproving the equation, and stating that there can be no accurate
predictions on whether M will a ect P.
Furthermore, the quantity theory of money is called into question on the basis of the
di culties in measuring and controlling the money supply. The money supply can be seen
as being made up of two parts: narrow and broad. Narrow money is essentially liquid
money used for transactions whereas broad money is the nancial assets that are not as
liquid or take time to liquidate, for example, government bonds. With the modern nancial
system based on electronic payments, the money supply has become much harder to
measure for authorities. This di culty undermines the validity of the quantity theory of
money and the sher equation as without knowledge of the key variable, no accurate
predictions on the correlation between the money supply and price level can be made.
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The quantity theory of money is a theory that states that in ation is linked to changes in
the money supply. Classical economists adhere to this theory. In ation occurs when the
money supply is increasing at a persistent rate greater than that of output within an
economy. The Fisher Equation operationalises this concept into the following equation:
MV = PY. M is the money supply, V is the velocity of circulation, P is the price level, and Y
is the output in the economy. Classicists state that both V and Y are constant, or at least
stable, and thus a direct link is provided between M and P, the money supply and price
level.
For example, say that the money supply is $80 billion, velocity is 5, price level is 100, and
output is $4 billion. The equation is correct: $80B x 5 = 100 x $4B, or $400B = $400B.
Now say that the money supply increase 50% to 120. Assuming that V and Y are
constant, the price level with also rise by 50% to 150.
Therefore, classicists view in ation as a monetary phenomenon. However, Keynesians
disagree with this. They argue that V and Y are not constant and can change with the
money supply as well, disproving the equation, and stating that there can be no accurate
predictions on whether M will a ect P.
Furthermore, the quantity theory of money is called into question on the basis of the
di culties in measuring and controlling the money supply. The money supply can be seen
as being made up of two parts: narrow and broad. Narrow money is essentially liquid
money used for transactions whereas broad money is the nancial assets that are not as
liquid or take time to liquidate, for example, government bonds. With the modern nancial
system based on electronic payments, the money supply has become much harder to
measure for authorities. This di culty undermines the validity of the quantity theory of
money and the sher equation as without knowledge of the key variable, no accurate
predictions on the correlation between the money supply and price level can be made.
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