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Economics

QUANTITY THEORY OF MONEY

Quantity Theory Of Money

This theory in its earnest form states that an increase in the quantity of money would bring about a proportionate in the price level i.e. the price level in proportional to the quantity of money in circulation.

Quantity theory of money was improved upon by Irving Fisher in 1920’s. It introduces two variables, volume of transaction and velocity of circulation.

The theory is express by the equation below,

MV = PT

Where, M = is the quantity of money

V = is the velocity of circulation of money

P = is the price level

T = is the volume of transactions (i.e. the quantity of goods)

From the equation, it can be deduced that general price level can be influenced not only by the change in quantity of money but also a change in the velocity of circulation of money and volume of production and also that a change in M or V can be offset by a contrary change in T. Thus, inflation is caused by increase in the supply of money.

VALUES OF MONEY

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The value of money refers to the purchasing power of money, that is, the quantity of goods and services which a given sum of money can buy.

There is an inverse relationship between price and value of money.

The higher the level of price, the lower the value of money and vice-versa, the value of money is not constant. It changes from time to time. For example, if a commodity cost #100 in 2010 and 2011, it has jump to #200, it means that the value of money has fallen.

If a #100 note can now buy 10 cups of garri instead of 5, this means an increase in the value of money.

FACTORS DETERMNING THE VALUE OF MONEY

  1. The general price level: There is an inverse relationship between the price level and value of money when price increases, the value of money falls because it can only buy few goods. On the other hand, when price reduces the value of money increases. It means money can buy more goods.
  2. The supply of money and its speed or velocity of circulation: If the quantity of money in circulation increases while there is little or no increase in the available quantity of goods and services, this would mean that a larger quantity of money would purchase fewer commodities.

The value of money therefore be low. On the other hand, a contraction in the supply of money would make money have a higher value (assuming that the supply of goods and services has not decreased). This is because a given sum of money would purchase more goods and services.

  1. The volume of goods and services available: If there is increase in the volume of goods and services and the supply of money is constant the value of money will increase. More goods and services can be purchased.

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