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Quantity theory of money is a classical theory of money demand, why? You will understand the concept of money demand, reasons to hold money, classical theory of money demand and implications of theory after reading this article. But before, we advise you to read the full article about quantity theory of money.

Concept of Money Demand

Although people do not hold idle cash balance, they hold some quantity of money for the transaction purpose. In fact, the demand for money is the quantity of money that people want to hold. However, in wider sense, demand for money is the monetary assets that consist of cash balance along with checking accounts that people want to hold in their portfolios.

Why people hold money? The reason is that they want to settle the financial transactions. In classical sense, people want to hold money only for the transaction purpose. That means demand for money does not depend on interest rate, it depends only on volume of transaction. This way, money only works as the medium of exchange in classical view. To sum up, the more transaction to settle, the more money people want to hold.

Classical Theory of Money Demand

Classical theory of money demand refers to the quantity theory of money. Now, let us start with the familiar equation of exchange, MV = Py, as we suppose that you have read it (if not, click here). We take this equation of exchange as given from the quantity theory of money.

The quantity theory of money links total money supply (M) to the total spending on goods and services (Py) in the economy. Velocity of money, V, is the concept that works as the link between total money supply and total spending.

Let’s rewrite equation of exchange dividing on both sides by V as,

M = 1/V (Py) …… (i)

Note that ‘M’ on the left hand side of equation (i) represents the total money supply in an economy. In addition, when money market is in equilibrium, money supply (M) equals money demand (Md) i.e.

M = Md ….. (ii)

Now, considering money market equilibrium, we can derive money demand function by replacing M by Md as, Md = 1/V (Py). Since, V is assumed to be constant, we can replace 1/V with some constant, k as

Md = k (Py) ….. (iii).

In fact, the equation (iii) is the money demand function, another way of interpreting Fisher’s equation of exchange. The equation tells us that certain portion of nominal spending is the amount of money people want to hold. This is why the quantity theory of money is the theory of money demand.

Money Demand Function in Real Terms

Dividing on both sides by P the equation (iii), we get the real money demand function as,

Md/P = k. y ….. (iv) .

The equation (iv) tells us about the real money balance, money balance
in terms of goods and services, that people want hold is proportional to real income.

Why Constant Velocity (V)?

In the equation of exchange MV = Py, a fall in V could offset a rise in M; thereby leaving MV and Py unchanged. Here, question arise to the stability of velocity (V): Is V stable?

Advancement in institutional (spending habits) and technological features (payment technology advances) may reduce the need for holding money balance. For example, increasing usages of bank cards and online payment systems are likely to reduce the demand for money relative to income. Similarly, spending habits of public may significantly change to cause the velocity of money.

However, Fisher’s assumption is that institutional and technological features change very gradually over time. Thus, velocity of money remains fairly constant over long period of time.

The constant velocity refers to the stable money demand function, which is prerequisite for the effective monetary management. Depending upon the stability of money demand, central monetary authority either target money supply or interest rate. If money demand is stable, definitely the target will be on money supply. That is tuning the money supply is to tune price and income.

Implications of Quantity Theory of Money

Let us present the following implications:

  • Price Level – the changes in quantity of money lead to the directly proportionate changes in price level.
  • Inflation – the quantity theory of money as the theory of inflation states that inflation is the difference between money supply growth and aggregate output growth. The justification rests upon the mathematical fact that percentage change of a product of variables is approximately equal to the sum of percentage changes of individual variables. Accordingly, we can write equation of exchange as,

%change in M + %change in V = %change in P + %change in y

Since V is constant, the percentage change is zero. So, %change in P (inflation) equals

%change in P = %change in M – %change in y.

  • Real income – classical economists believe that wages and prices are flexible enough to restore economy to the full employment level of equilibrium. To know why, read Say’s Law of Market. In addition, the full employment level of output depends on the economy’s aggregate production function and qualities of available resources. Both of these facts imply that changing money supply, which leads to directly proportionate change in price level and thus nominal income, does not alter the real aggregate output. There is complete separation between nominal and real variables like money, income, wage and interest rate. Classical economists term this separation as classical dichotomy.

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