Question

What is the quantity theory of Money Demand ? What determines the demand for money, according to this theory? What potential determinants of money demand does the quantity theory leave out? Explain. In our alternative formulation of money demand, explain what happens when there is an excess demand for money: what will change, and how, to eliminate the excess demand?

Answer 1

Quantity theory of money demand states that there is a direct relationship between the quantity of money prevalent in an economy and the level of prices of goods and services. Thus according to the theory there is direct relationship i.e with an increase in money supply, prices would rise.

Demand for money is determined by the currency in circulation, the more the money supply, more is the demand for money. It doesn't take into consideration the GDP of an economy, the preferences and tastes of the consumer to spend on particular goods and services beyond a certain point.

When there is excess demand for money in an alternative formulation of money demand, people will spend more and there will be excess demand, in order to eliminate this excess demand, firms will spur investment and this will lead to increase in production levels in the economy. Thus supply meets demand to eradicate the excessive price rise.