In monetary economics, the quantity theory of money states that the general price level of goods and services is directly proportional to the amount of money in circulation, or money supply.
Quantity Theory Of Money
What is the ‘Quantity Theory Of Money’
The quantity theory of money is a theory about the demand for money in an economy. The most common version, sometimes called the “neo-quantity theory” or Fisherian theory, suggests there a mechanical and fixed proportional relationship between changes in the money supply and the general price level. This popular, albeit controversial, formulation of the quantity theory of money is based upon an equation by American economist Irving Fisher.
Explaining ‘Quantity Theory Of Money’
The Fisher equation is calculated as:
Where: M represents the money supply.
The Irving Fischer Model
The Fisher model has many strengths, including simplicity and applicability to mathematical models. However, it uses some spurious assumptions to generate its simplicity, including an insistence on proportional increases in the money supply, variable independence and emphasis on price stability.
Competing Quantity Theories
Keynesians more or less use the same framework as monetarists, with few exceptions. John Maynard Keynes rejected the direct relationship between M and P, as he felt it ignored the role of interest rates. Keynes also argued the process of money circulation is complicated and not direct, so individual prices for specific markets adapt differently to changes in the money supply. Keynes believed inflationary policies could help stimulate aggregate demand and boost short-term output to help an economy achieve full employment.
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