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Quantity theory of money

Classical dichotomy:

1.      theory of value with marginal analysis. Y, w, (W/P), r

2.      Theory of money with trade cycle and price level, W P PY i(money rate of i)

Fishers Version (equation of exchange)

P' average price of transaction T

P'T is the monetary value of all transactions.

V' rate that a unit of M changes hands

In money using economy where non-monetary transactions are insignificant


T is determined in the real sector, tends towards T* (fullempl). V' is given in short run.

M does not depend on P'T (closed econnomy). In long run only

i=r + dP/P=r+dM/M

Income version of Fisher

P' measures also intermediate transactions. PY =GDP where P is price index. V becomes income velocity of circulation.

Cambriidge cash balance version

M=kPY - cambridge approach. k - desired money to money income ratio.

If overnight the moeny supply were to double. The price level would also double. Money is mutual, money things dont affect real things. Assumption:

1.         k is stable in shortrun

2.         M-is exogenously given - it is now the creation of the money system. So it is not that true.

The rate of inflation p dot `p.

The money using economy is a good thing.

Money is not only a medium of exchange but a temporary abode of purchasing power. So there was a demand for money. This was mainly influenced by national income (also by r, but not here)

Only in full monetary equilibrium M=Md.

Ms and Md are brought into equilibrium by changes in P as Y is already Y* (cash-balance effect).

Hume said that in long-run money is neutral (Ms represents the value of economy). When country imports gold initially wages in exporting sectors rise (terms of trade change), but these workers will bid up the general price level.

Marshallian-Wicksellian monetary transmission mechanism

was invented because cash-balance could not explain open market operations. But they said again that monetary things could influence real interest rate inthe short run.

Forced savings will occur. So k is a function of r monetary. As monetary r tends to natural in LR, k is stable.

Friedman carried it on

and looked of excessive Ms expansion because the Bank tries to maintain r at unnatural level. He said one can't judge whether interest is high or low. It should be natural. A full-blown inflation will emerge (Bank increases Ms, prices and r will start going up). Then i and r will be expected to be different. Ms targets should be better ones. He told high interest is the result of lax monetary policy (paradox with Keynes) as inflation is high. Keynes said also interest should not be kept too low, but when not at full employment r must be below rn and thus Ms should be expanded etc.

The monetary transmition mechanism

MV=PY restrict this equation - doubling of M will lead to a doubling of P.

The cambridge approach Md=kPY has advantage k - the money the individuals wish to hold at their income. That is the demand relation. The supply was given exogenously.

When money supply increases (budget deficit G-T-gilts to private) through open market operations. Assume at the beginning Ms=Md=kPY, wher Ms increases there is imbalance. Individuals find themselves with money balances that are excessive.

Ms-Md= - ive. Yd-Y* = +ive. Y* is max. output, so now there is no possible extra output. So the price level will rise. If the supply of money is oneoff, the prices will not rise infinitely. As prices rise Md wil rise until Md=Ms.

Quantity theory of money in international context

Price - Specie - Flow mechanism.


This drains countrys gold reserves.

The price of british produced goods falls, the price of foreign good rises. This will increase british exports.


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