Question

Use equations and argument to reveal why the Quantity Theory of Money is unlikely to hold on a consistent basis (the argument Keynes made is an example of how to do this).

Answer 1

In its simplest form, it states that the general price level (P) in an economy is directly dependent on the money supply (M);

P = f(M)

If M doubles, P will double. If M is reduced to half, P will decline by the same amount. This is the essence of the quantity theory of money.

This equation is an identity that always holds true: It tells us that the total stock of money used for transactions must equal to the value of goods sold in the economy. In this equation, supply of money consists of nomi­nal quantity of money multiplied by the ve­locity of circulation.

Like the price of a commodity, value of money is determinded by the supply of money and demand for money. In his theory of demand for money.

As a truism, in a given time period, total money expenditure is equal to the total value of goods traded in the economy. In other words, national expenditure, i.e., the value of money, must be identically equal to national income or total value of the goods for which money is exchanged, i.e.,

MV = ? piqj = PT ….(4.1)

where

M = total stock of money in an economy;

V = velocity of circulation of money, that is, the number of times a unit of money changes its hand;

Pi = prices of individual goods;

?P = p1q1 + p2q2 + … + pnqn are the prices and outputs of all individual goods;

qi = quantities of individual goods transacted;

P = average or general price level or index of prices.

T = total volume of goods transacted or index of physical volume of trans­actions.