money demand theory

The Quantity Theory of Money (QTM) is an economical model used to explain changes in the general level of prices in the economy. It states that the amount of money circulating in the economy has a direct and proportional correlation with the level of prices. The underlying concept of the QTM is that people’s primary focus when attempting to maximize their well-being is to obtain commodities and services that provide satisfaction or utility in a particular period of time.

Specifically, QTM states that the changes in the general level of prices are proportional to the amount of money circulating in the economy. In other words, an increase in the amount of money in circulation leads to an overall increase in prices. This can be seen through the equation of exchange, which states that the “total amount of money in circulation multiplied by velocity is balanced on the other side by prices multiplied by the quantity of goods traded” (Mankiw, 2018, p. 205). Specifically, the equation states that if the quantity of money increases, for a given level of velocity it must be accompanied by an increase in prices for the same quantity of goods to be in equilibrium.

The relationship between the amount of money in circulation and the general level of prices has been a topic of interest for a number of economists both past and present. The QTM was originally proposed by British philosopher and economist, William Stanley Jevons, in his 1875 book, Money and the Mechanism of Exchange. It is generally thought to be the foundation of Irving Fisher’s equation of exchange, which also became well known.

Though the QTM serves as a useful tool for understanding a variety of economic phenomena, it is not without its detractors. One of the primary criticisms of the theory is that it does not account for velocity - the number of times money changes hands in a given period. Critics claim that the equation of exchange implicitly assumes that velocity remains the same even when money supply changes. This is problematic as it overlooks potential changes in velocity which could impact prices.

Additionally, many economists have argued that the QTM does not account for ‘real’ economic factors such as population growth, overall level of economic production, or the wealth of an economy. These argue that an increase or decrease in money supply cannot be the sole factor determining changes in the general level of prices and that the QTM fails to reflect the complexities of economic processes.

Despite the criticisms of the QTM, it remains a useful tool which is well accepted by many in the economic community. It serves to provide insight into an often difficult to understand phenomenon – how changes in the money supply affect changes in prices. Though it is not without fault, the QTM provides an insight into the relationship between money and prices that can be utilized to better understand the economy and guide economic policy.

Bibliography

Mankiw, N. G. (2018). Principles of Economics. Harlow, England : Pearson.

The quantity theory of money is an economic theory that states the total amount of money held by the public within an economy determines the level of economic activity. The theory also states that if the amount of money increases faster than economic activities, then the general price level of goods and services in the economy will go up. This theory is closely related to the inflationary process in an economy.

The quantity theory of money suggests that changes in the total amount of money in an economy have a direct impact on the prices of goods and services in the economy. Thus, an increase in the money supply will lead to a corresponding increase in the prices of goods and services. The exact nature of the relationship between the money supply and prices is not well understood, but it is generally agreed upon that a rapid increase in the money supply results in rapid inflation.

In a closed economy, changes in the money supply are usually determined by the central bank. For example, it may increase or reduce the money supply in order to influence economic activity. By increasing the money supply, the central bank can make more money available to the public, which will lead to increased consumption and investment spending. Such increased spending should in turn lead to economic growth. On the other hand, if the money supply is reduced, then consumption and investment spending will be reduced, leading to economic slowdown.

The quantity theory of money can be used to explain certain economic phenomena. It can be used to explain why high inflation is often accompanied by an increase in unemployment. When the money supply increases rapidly, prices of goods and services tend to rise faster than consumers’ wages, leading to decreased purchasing power. This decrease in purchasing power leads to reduced spending, which can then lead to decreased demand for certain goods and services, resulting in higher unemployment.

In conclusion, the quantity theory of money suggests that changes in the total amount of money circulating in an economy have a direct effect on prices and economic activity, including unemployment. Thus, central banks can use the money supply to influence economic activity in the short run. They can also use it to reduce the effects of inflation and deflation, or in other words, to maintain price stability.