Chapter 6 complete

6.3 Quantity Theory of Money (QTM) Approach
The concept of the quantity theory of money began in the 16
th
century. As gold and silver 
inflows from the American into Europe were being minted into coins, there was a resulting 
rise in inflation (because more minted coins means more supply of money and more supply 
of money leads to increase in price of commodity, which result into inflation.) This led 
economist Henry Thornton in 1802 to assume that more money equals more inflation and that 
an increase in money supply does not necessarily mean an increase in output. The QTM 
states that there is a direct relationship between the quantity of money in an economy and the 
level of prices of goods and services sold. Another way to understand the QTM is to 
recognise that money is like any other commodity: increases in its supply decreases its 

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marginal value (or the purchasing capacity of one unit of currency). So an increase in money 
supply causes prices to rise (inflation) and when prices of commodity rises, the value of 
currency decreases. The quantity theory of money was developed by the classical economists 
over 100 years ago, related the amount of money in the economy to nominal income. The 
quantity theory of money was first propounded by an Italian economist, Davanzatti in 1588.
Classical economists like David Ricardo, David Hume and J. S. Mill have improved this 
theory. The credit for popularising this theory goes to American economist, Irving Fisher.
Say’s law (supply creates its own demand) of markets is the foundation for a 
simplistic view of the macroeconomy known as the Quantity Theory of Money. This theory 
begins with the premise that because of the self-correcting nature of the economy, it will 
always be in equilibrium with the aggregate quantity supplied equal to the aggregate quantity 
demanded at some price level. According to this theory, the value of the aggregate quantity 
supplied is equal to the physical quantity produced (Q) times the equilibrium price level (P). 
The value of the aggregate quantity demanded is equal to the amount of money in the system 
(M) times the velocity (V) with which the money changes hands
1
. V is called the transactions 
velocity of money and measures the rate at which money circulates in the economy. In other 
words, V tells us the number of times a given currency (i.e., Rs.) changes hands in a given 
period of time. If a single Rs.1 is used for 10 transactions during a given year, then the total 
quantity of goods and services that can be demanded with that Rs.1 will be Rs.10 per year. 
Hence we have: 
Value demanded = Amount of money in the system (M) X Velocity of money (V) = MV 
Value supplied = Quantity produced (Q) X Equilibrium Price level (P) = QP 
Say’s Law stipulates that “supply creates its own demand” as shown in the Figure 6.1. 
According to Say’s Law of Markets, the closed circular flow of income contained a self-
correcting mechanism that would automatically stabilising the system, should it temporarily 
get out of balance. For example, the market is in equilibrium at point E (i.e., at Qe = 60 level 
of output on P = 12). If price increases to P1 = 16.quantity demanded for goods and services 
falls to 40 quantity of supply increases to 80. Since demand for goods is less than the supply 
of goods, price falls to the equilibrium level of output at Qe = 60 as shown in Figure 6.1. 
Since the value of quantity supplied and demanded are presumed to be in equilibrium, it 
follows that: 
MV = PQ (the Fisher Equation) 
6.2 
This equation will be discussed in detail in Irving Fisher’s Transaction Approach. The 
most striking support for the quantity theory of money comes from the experience of 
extremely rapid inflations. During the German hyperinflation of 1922-23, the price level rose 
an average of 322 per cent per month. The quantity of currency increased an average of 314 
per cent per month. The hyperinflation in Greece between 1943 and 1946 saw rated of 
monetary growth and inflation peak at several thousand per cent per month. 
1.
Goodwin, John, W; Drummond, H. Evan, 1982, Agricultural Economics, Reston Publishing Company: 
107.

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Those nations that suffered above average inflations today 
increasing money stocks. The accumulate evidence, then, leads monetarists to conclude that 
the quantity theory approach to inflation is essentially correct
monetarist thought is the quantity theory of money
theory of money is that a change in the stock of money will, in the long run and other things 
being the same, lead to a proportional 
permanent effect of increasing th
The value of money (Vm) is determined at the point where demand for money (Dm) 
equals supply of money (Sm). In equilibrium form it can be written as Vm = Dm = Sm. If 
supply of money remain constant; incr
money or decreases the price level and vice versa. In other words when value of money 
increases, price of commodity (price level ) decreases. There is an inverse relationship 
between price level and value of 
money can be shown in equation, Vm = 1/P. For example, if price of commodity X is Rs. 10 
and if price of X increases from Rs. 10 to Rs.20, the value of money will fall down, this 
means purchasing power of money falls so that Vm = 1/20. Now, with increase in price of X, 
one unit of currency can buy only half of the commodity X. Value of money is determined 
by the demand for and supply of money. In this regard, there are 
Quantity theory of money, (2) 
(4) The Real Balance Effect. 
Irving Fisher’s Transaction Approach
(ii) Cash-balance Approach or Cambridge Approach
(iv) Post Quantity Theory of Money or Milton Friedman’s Quantity Theory of Money or
2. Kamerschen, David, R; et al, 1989, Economics, Houghton Mifflin Company: 378
Those nations that suffered above average inflations today invariably have rapidly 
increasing money stocks. The accumulate evidence, then, leads monetarists to conclude that 
the quantity theory approach to inflation is essentially correct
2
. The theory underlying 
quantity theory of money. The basic proposition of the quantity 
that a change in the stock of money will, in the long run and other things 
, lead to a proportional change in the price level. In other words, the only 
permanent effect of increasing the quantity of money is to increase the price level.
The value of money (Vm) is determined at the point where demand for money (Dm) 
equals supply of money (Sm). In equilibrium form it can be written as Vm = Dm = Sm. If 
supply of money remain constant; increase in demand for money increases the value of 
money or decreases the price level and vice versa. In other words when value of money 
increases, price of commodity (price level ) decreases. There is an inverse relationship 
between price level and value of money. The relationship between price level and value of 
shown in equation, Vm = 1/P. For example, if price of commodity X is Rs. 10 
and if price of X increases from Rs. 10 to Rs.20, the value of money will fall down, this 
er of money falls so that Vm = 1/20. Now, with increase in price of X, 
one unit of currency can buy only half of the commodity X. Value of money is determined 
by the demand for and supply of money. In this regard, there are four
(2) Income Theory of money (3) Liquidity theory of money
Quantity theory of money may be divided into 
Irving Fisher’s Transaction Approach or Cash Transaction Approach or C
balance Approach or Cambridge Approach, (iii) Keynes’ reformulation of the QTM 
Post Quantity Theory of Money or Milton Friedman’s Quantity Theory of Money or
, David, R; et al, 1989, Economics, Houghton Mifflin Company: 378
invariably have rapidly 
increasing money stocks. The accumulate evidence, then, leads monetarists to conclude that 
The theory underlying 
The basic proposition of the quantity 
that a change in the stock of money will, in the long run and other things 
In other words, the only 
e quantity of money is to increase the price level.
The value of money (Vm) is determined at the point where demand for money (Dm) 
equals supply of money (Sm). In equilibrium form it can be written as Vm = Dm = Sm. If 
ease in demand for money increases the value of 
money or decreases the price level and vice versa. In other words when value of money 
increases, price of commodity (price level ) decreases. There is an inverse relationship 
money. The relationship between price level and value of 
shown in equation, Vm = 1/P. For example, if price of commodity X is Rs. 10 
and if price of X increases from Rs. 10 to Rs.20, the value of money will fall down, this 
er of money falls so that Vm = 1/20. Now, with increase in price of X, 
one unit of currency can buy only half of the commodity X. Value of money is determined 
four approaches: (1) 
Liquidity theory of money, and 
ded into many parts: (i) 
Classical Approach, 
(iii) Keynes’ reformulation of the QTM 
Post Quantity Theory of Money or Milton Friedman’s Quantity Theory of Money or

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ChicagoVersion of QTM, (v) Money, Prices, and Inflation. Liquidity theory of money is 
divided into two heads viz; (i) Radcliffe-Sayers’ version of the liquidity theory of money, and 
(ii) Gurley-Shaw version of the liquidity theory of money. The real balance effect is also 
divided into two heads viz; (i) the Pigou effect, and (ii) the Patinkin’s integration of monetary 
theory and real sectors.