Complete Explanation of the Quantity Theory of Money and Its Full Formula
The Financial Services Authority (OJK) defines the Quantity Theory of Money as a theory that explains the relationship between money, price levels, and the economy, particularly how inflation can be controlled by managing the money supply.
The Quantity Theory of Money is also known as the Quantity Theory of Money in English.
Definition of the Quantity Theory
The Quantity Theory of Money is an economic theory that states there is a relationship between the money supply and inflation levels. The theory was introduced by Irving Fisher, an American economist. This theory is typically used in monetary transmission processes related to money supply.
The core idea behind this theory is that inflation is directly influenced by the growth and quantity of money in circulation.
It also explains that the general price level of goods and services is directly proportional to the amount of money circulating in the economy. While this theory was challenged by Keynesian economists, it was later updated and modified by monetarists.
Although economists may disagree on its short-term accuracy, most agree that the Quantity Theory of Money holds true in the long run.
In modern discussion, this theory is often referred to as the Neo-Quantity Theory or Fisher’s Theory, which emphasizes a mechanical and proportional relationship between changes in the general price level and changes in the money supply.
Irving Fisher’s Quantity Equation
Irving Fisher formulated the theory using the following equation:
M × V = P × T
Where:
M = Money supply
V = Velocity of money
P = Average price level
T = Volume of transactions in the economy
This theory suggests that an increase in the money supply tends to lead to inflation, and vice versa. For example, if the European Central Bank increases the money supply, prices in the economy may rise significantly in the following period.
Originator of the Quantity Theory of Money
Irving Fisher is credited as the founder of the Quantity Theory of Money, which later became a key component of the theory of money demand. Fisher believed there is always a financial equilibrium within society.
He argued that the primary function of money is as a medium of exchange, where the amount sellers receive and buyers pay remains balanced.
In any given period, the value of goods or services purchased equals the value of those sold. The value of sold goods is calculated by multiplying transaction volume with the average price.
The money supply equals the value of goods transacted multiplied by the average number of times money changes hands during that period.
Initially, Fisher’s theory was not intended as a monetary theory, but over time, it developed into one with the following key assumptions:
- Money is always used in transactions.
- Financial institutions influence how money is held in society.
- In the short term, the money supply is constant.
- Public expenditure reflects national income and determines transaction volume.
Perspectives on the Quantity Theory of Money
Economists use this theory to analyze macroeconomic conditions. It explains how the supply of money relates to price levels in the economy. There are three primary views on this theory:
1. First Perspective
The entire money supply is used for transactions, specifically for purchasing goods or services.
2. Second Perspective
This view assumes a constant money supply, with individual spending and money-holding behavior remaining stable over time.
3. Third Perspective
This assumes that the economy always operates at full employment, meaning national output is already at its maximum level and cannot be increased further.
Criticism of the Quantity Theory of Money
One of the main criticisms comes from economist John Maynard Keynes, who challenged the classical economists’ views on money’s impact on prices and economic activity.
According to Keynes, price changes are not always caused by changes in the money supply. He argued that national income changes are not solely driven by money supply either.
Keynes acknowledged that prices may rise when money supply increases, but the increase in prices is not always proportional to the increase in money.
He also noted that the theory is not applicable in economies with high unemployment, as it assumes full employment. Keynes revised the theory by introducing cost-push inflation, where production costs also influence prices along with the money supply.
In conclusion, the Quantity Theory of Money suggests that the purchasing power of money is determined by the amount of money in circulation. Money demand is inversely related to money supply.
The more money circulates, the lower the purchasing power, and vice versa. The money supply corresponds to the general price level in the market. An increase in money supply leads to rising prices, and conversely, a decrease can lead to lower prices.
Download Transfez App
Transfez App can help you transfer money abroad more quickly and efficiently. Jack Finance can also help your business in making transactions abroad. For those of you who want to send money to relatives who are abroad because they are studying, working, or traveling, Transfez will be ready to help. This app is available on Android as well as iOS.
