Assumptions of quantity theory of money. Assumptions_and_Criticisms.pdf 2022-11-07
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The quantity theory of money is a theory in economics that explains the relationship between the quantity of money in an economy and the price level. This theory is based on the assumption that the quantity of money in circulation is a key determinant of the overall level of prices in an economy. According to the quantity theory of money, an increase in the quantity of money will lead to an increase in the price level, and a decrease in the quantity of money will lead to a decrease in the price level.
There are several assumptions that underlie the quantity theory of money. These assumptions include:
The velocity of money is constant: The velocity of money refers to the rate at which money circulates in an economy. According to the quantity theory of money, the velocity of money is assumed to be constant. This means that the rate at which money circulates in an economy does not change as the quantity of money changes.
The demand for money is stable: The quantity theory of money assumes that the demand for money is stable. This means that people's desire to hold money as a store of value does not change as the quantity of money in circulation increases or decreases.
The supply of goods and services is fixed: The quantity theory of money assumes that the supply of goods and services in an economy is fixed. This means that the quantity of goods and services available for purchase does not change as the quantity of money in circulation increases or decreases.
The economy is at full employment: The quantity theory of money assumes that the economy is at full employment, meaning that all available resources are being used to produce goods and services. This assumption means that changes in the quantity of money will not affect the overall level of employment in the economy.
Prices are flexible: The quantity theory of money assumes that prices are flexible, meaning that they will adjust to changes in the quantity of money in circulation. This means that if the quantity of money increases, prices will rise, and if the quantity of money decreases, prices will fall.
Overall, the quantity theory of money is a theory that explains the relationship between the quantity of money in an economy and the overall level of prices. It is based on several assumptions, including the constancy of the velocity of money, the stability of the demand for money, the fixity of the supply of goods and services, the assumption of full employment, and the flexibility of prices.
Quantity Theory of Money by Friedman
According to Keynes, as long as there is unemployment, every increase in money supply leads to a proportionate increase in output, thus leaving the price level unaffected. We find nothing to interfere with the truth of the quantity theory that variations in money M produce normally proportional changes in prices. The general situation is one of the under-employment equilibrium. Long Period: The theory is based on the assumption of long period. Accordingly the cost of holding various assets except human capital can be measured by the rate of interest on various assets and the expected change in their prices.
In order words, it neglects the store-of-value function of money and considers only the medium-of-exchange function of money. The relative or real prices are determined in the commodity markets and the absolute or nominal prices in the money market. ADVERTISEMENTS: Consequently, the price level may change more in proportion to a change in the quantity of money. As a result, total payments made during the said time interval, say a year, are always equal to the money value of the items sold during that period. The total volume of transactions multiplied by the price level PT represents the demand for money. Leaders in both of these countries, such as Margaret Thatcher and Ronald Reagan, tried to apply the principles of the theory in order to achieve money growth targets for their countries' economies.
Fisher’s Quantity Theory of Money: Equation, Example, Assumptions and Criticisms
It is a hotchpotch price level, which is of no use to anyone. This is because when money growth surpasses the growth of economic output, there is too much money backing too little production of goods and services. Second, it gives undue importance to the price level as if changes in prices were the most critical and important phenomenon of the economic system. Thus, the equation of exchange becomes: ADVERTISEMENTS: e The volume of trade T. ADVERTISEMENTS: Secondly, Friedman distinguishes between two types of demand for money. The quantity theory of money states that quantity of money is the main determinant of the price level or the value of money. In this equation, supply of money consists of nominal quantity of money multiplied by the velocity of circulation.
Quantity Theory of money (Fisher’s): Assumptions and Criticism
It is changes in money stock that are the cause, not the effect. The supply of money is assumed as an exogenously determined constant. In the first type, money is demanded for transaction purposes. Milton Friedman, the leading monetarist, is of the view that the quantity theory was not given full chance to fight the great depression 1929-33; there should have been the expansion of credit or money or both. Money is not demanded for its own sake but for the sake of things that if helps to buy. On the other hand, a lower rate of interest creates an increase in the demand for money.
What are the assumptions on which the Quantity Theory of Money by Fisher is based?
By implication, it is not possible to measure P and T separately and we always get a measure of their product PT. Criticisms of the Theory: The Fisherian quantity theory has been subjected to severe criticisms by economists. Such a situation arises when wages and prices are rigid downward. They of course admit that there are many differences between the persons within a same socio-economic group; some have great preference for gambling and others are unwilling to take any risk at all. Unrealistic Assumptions: Keynes in his General Theory severely criticized the Fisherian quantity theory of money for its unrealistic assumptions.
Unrealistic Assumption of Long Period: The quantity theory of money has been criticised on the ground that it provides a long-term analysis of value of money. Fails to Integrate Monetary Theory with Price Theory: The classical quantity theory falsely separates the theory of value from the theory of money. Thus it neglects the short run factors which influence this relationship. Money is accepted by sellers so as to pay for their own purchases. Quantity Theory of Money— Fisher's Version: Like the price of a commodity, value of money is determinded by the supply of money and demand for money. There is no correlation between permanent and transitory consumption. Revival of Quantity Theory: In the recent times, the monetarists have revived the classical quantity theory of money.
The Fisher's Quantity Theory of Money (Assumptions and Criticisms)
This is in contrast with the fact that the entire economic theory makes use of the basic response of both demand and supply flows to changes in prices. But the classical economists recognised the existence of frictional unemployment which represents temporary disequilibrium situation. Price level is also a stock variable, but is being measured over a time interval. If there is an increase in money supply, the supply curve shifts to M 1S 1. The demand for money is essentially the demand for transaction purposes. But by 20th century, the theory had received sophisticated treatment at the hands of Fisher, Pigou and Keynes. First, the quantity theory of money for its unrealistic assumptions.
The Fisher's Quantity Theory of Money (Assumptions and Criticisms) (2022)
Indicate which effect each description in the following table represents with respect to the interest rate. Friedman is an uncompromising supporter of the free market mechanism. In other words, the quantity theory assumes that in the long run the economy tends to full employment. For instance, QTM predicts that price levels will double if the amount of money in an economy twice. Fails to Explain Trade Cycles: The quantity theory does not explain the cyclical fluctuations in prices. First, the quantity theory of money is unrealistic because it analyses the relation between M and P in the long run. If the transitory income is positive, the measured income will be higher than the permanent income; if it is negative it will be lower than the permanent income.
According to the assumptions of the quantity theory of money, if the money supply decreases by 7
It ignores the importance of many other determinates of prices, such as income, expenditure, investment, saving, consumption, population, etc. In a broad sense money includes currency, demand deposits and time deposits which yield interest. During a given period of time, no payments are made for purchases done during any earlier period, and nothing is purchased on credit. The complicated model of the Keynesian theory of money and prices is shown diagrammatically in Figure 67. The fact is that prices change on account of several factors.
The Keynesian Theory of Money and Prices (Assumptions, Superiority and Criticisms)
Further, when the quantity of money is increased four-fold to M 4, the price level also increases by four times to P 4. According to Patinkin, Fisher gives undue importance to the quantity of money and neglects the role of real money balances. There is no repercussive or second-round change in M TV. The theory is applicable in the long run. Consequently, certain bottlenecks appear which raise the marginal cost including money wage rates. But this is not true.