The Quantity Theory of Money seeks to explain the factors that determine the general price level in a country. The theory states that the price level is directly determined by the supply of money. There are two versions of the Quantity Theory of Money: (1) The Transaction Approach and (2) The Cash Balance Approach. Let us discuss them in detail.
The Transaction Approach:
Fisher’s transaction approach to the Quantity Theory of Money may be explained with the following equation of exchange.
MV = PT
Where, M is the total supply of money
V is the velocity of circulation of money
P is the general price level
T is the total transactions in physical goods.
This equation is an identity, that is, a relationship that holds by definition. It means, in an economy the total value of all goods sold during any period (PT) must be equal to the total quantity of money spent during that period (MV). Fisher assumed that (1) at full employment total physical transactions T in an economy will be a constant, and (2) the velocity of circulation remain constant in the short run because it largely depends on the spending habits of the people. When these two assumptions are made the Equation of Exchange becomes the Quantity Theory of Money which shows that there is an exact, proportional relationship between money supply and the price level. In other words, the level of prices in the economy is directly proportional to the quantity of money in circulation. That is, doubling the total supply of money would double the price level.
It may be noted that the above Fisher’s Equation include only primary money or currency money. But modern economy extensively uses demand deposits or credit money. It was on account of the growing importance of credit money that Fisher later on extended his equation of exchange to include credit money.
Fisher’s Transaction Approach can explain the causes of hyperinflation that occurs during war or emergency. It can also explain certain long term trend in prices. But it cannot explain normal peace time inflation. This shortcoming has been modified by the Cambridge version or the Cash-Balance Approach.
The Cash-Balance Approach: The Cash-Balance Approach to the Quantity Theory of Money may be expressed as:
p = kR/M …………………………(1)
where p = the purchasing power of money
k = the proportion of income that people like to hold in the form of money;
R = the volume of real income; and
M = the stock of supply of money in the country at a given time.
This equation shows that the purchasing power of money or the value of money (p) varies directly with k or R, and inversely with M.
Since p is the reciprocal of the general price level; that is p = 1/P, the equation, p = kR/M can be expressed alternatively as:
1/P = kR/M ……………………..........(2)
or M = kRP ………………………...(3)
If we multiply the volume of real income (R) by the general price level(P), we have the money national income(Y). Therefore,
M = kY …………………………….........(4)
where Y is the country’s total money income. We can also write equation (3) in terms of the general price level thus:
P = M/kR ………………………...........(5)
This equation implies that the price level (P) varies inversely with k or R and directly with M.
In the Cash Balance approach k was more significant than M for explaining changes in the purchasing power (or value) of money. This means that the value of money depends upon the demand of the people to hold money.
SUPERIORITY OF THE CASH BALANCE APPROACH
The Cash Balance approach to the Quantity Theory of Money is superior to the Transaction Approach on the following grounds.
1. The Transaction approach emphasizes the medium of exchange function of money only. On the other hand, the Cash Balance approach stresses equally the store of value function of money. Therefore, this approach is consistent with the broader definition of money which includes demand deposits.
2. In its explanation of the determinants of V, the Transaction approach stresses the mechanical aspects of the payments process. In contrast, the Cash Balance approach is more realistic as it is behavioral in nature which is built around the demand function for money.
3. As to the analytical technique, the Cash Balance approach fits in easily with the general demand-supply analysis as applied to the money market.
This feature is not available in the Transaction approach.
4. The Cash Balance approach is wider and more comprehensive as it takes into account the income level as an important determinant of the price level. The Transaction approach neglected income level as the determinant of the price level.
5. According to the Transaction approach, the change in P is caused by change in M only. In the Cash Balance approach P may change even without a change in M if k undergoes a change. Thus k, according to the Cash Balance approach is a more important determinant of P than M as stressed by the Transaction approach.
6. Moreover, the symbol k in the Cash Balance approach proves to be a better tool for explaining trade cycles than V in Fisher’s equation.