The Modern Quantity Theory Of Money

The Quantity Theory of Money, Modern Quantity Theory of Money

Classical and neoclassical theorists maintained an interest in at least one macro-economic question: what determines the general level of prices? They addressed this economic question by utilizing the supply-and-demand approach developed in microeconomic theory. The supply of money was assumed to be determined by the monetary authorities, so some orthodox economists contended that the basic issues to be analyzed were on the side of demand. The household and firm are assumed to be rational and to have a demand for money to be used for various purposes. Walras, Menger, and others developed a supply-and-demand analysis to explain the value of money, but the most famous of these theories is probably the one developed by Marshall, which has become known as the Cambridge cash-balance version of the quantity theory of money.

The first clear statement of the quantity theory of money was made by David Hume in 1752. This theory, as it came down through the literature, held that the general level of prices depended upon the quantity of money in circulation. Marshall's version of the quantity theory was an attempt to give microeconomic underpinnings to the macroeconomic theory that prices and the quantity of money varied directly. He did this by elaborating a theory of household and firm behavior to explain the demand for money. Marshall reasoned that households and firms would desire to hold in cash balances a fraction of their money income. If M is money (currency plus demand deposits), PY is money income, and k is the proportion of their income that households and firms desire to hold in the form of money, then the fundamental cash-balance equation is

M = kPY

Because Marshall accepted Say's Law, full employment is assumed. An increase in the quantity of money, assuming k remains constant, will lead to an increase in money income, PY. Because full employment is assumed, an increase in the quantity of money will result in higher prices and a consequent increase in money income; real income, however, will not change. Decreases in the quantity of money will result in a fall in money income as prices fall; real income again will remain constant. We shall not examine the many different aspects of Marshall's formulation; the important point is that Marshall's version of the quantity theory made an attempt to integrate the microeconomic behavior of maximizing firms and households with the macroeconomic question of the general level of prices. A group of economists, the most prominent being the American Irving Fisher (1869-1947), developed another form of the quantity theory known as the transactions version. However, they showed little interest in finding a micro-economic foundation for the macroeconomic analysis of the general level of prices. In this version,


where M is the quantity of money, V is the velocity of money, P is a measure of the price level, and T is the volume of transactions.

Although these two approaches have important differences, they have one element in common: they were both designed to explain the forces that deter­mine the general price level. They were not used to explain the level of real income, which was assumed to be at full employment and fixed by nonmonetary forces in the economy.

Not all economists were satisfied with this analysis. For example, Knut Wicksell (1851-1926) argued that the quantity theory of money failed to explain "why the monetary or pecuniary demand for goods exceeds or falls short of the supply of goods in given conditions." Wicksell tried to develop a so-called income approach to explain the general level of prices; that is, to develop a theory of money that explains fluctuations in income as well as fluctuations in price levels.