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QUANTITY THEORY

Ahmad Cahyo Nugroho

What is quantity theory?

• Supply of money• Demand of Money

Crude Quantity Theory

• The value of money varies inversely with theamount of money in circulation

• When linked to the price of good andservices?

Crude Quantity Theory

M = k.P or P = M/k

• When:– M = Amount of Money– k = Constant– P = Price

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Crude Quantity Theory

• This theory is very simple, and doesn'tdescribe the actual state of condition

Quantity theory by Irving Fisher

• There are 3 factors that influence the value ofmoney:– Volume of Money– Velocity of Money– Volume of Trade

Quantity theory by Irving FisherIf E is Expenditure or total amount o• E = M x V …………………………… (1)• E = T x P …………………………… (2)• M x V = T x P …………………………… (1 + 2)

• E = Expenditure• M = money supply• V = speed of circulation of the money (M)• P = price level• T = quantity of goods and services produced

Quantity theory by Irving Fisher• What influence Money Supply:

– Monetary Basis– Creation of Money– Reserve Requirements

• What Influence velocity of money:– Payment Frequency– Spending Habit– Saving Habit– Investment Habit

• What Influence Volume of Trade:– Quality and Quantity on Production Factor– Employment– Business Specialization and Organization

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Quantity theory by Irving Fisher

• M ↑, V and T remains sl l P ?• V ↑ , M and T remains sl l P ?• T↑, M and V remains sl l P ?

Quantity theory by Irving Fisher

• M ↑, V and T remains sl l P ↑• V ↑ , M and T remains sl l P↑• T↑, M and V remains sl l P↓

Quantity theory by Irving Fisher

• The assumptions underlying Fisher's theory is:– The price level (P) is a passive factor in the

equation.– Fisher assumed that all sources have full

employment economy.– Among the factors that affect V is the payment

habits of the people considered to be sufficientlystable or permanent.

– Comparison between the number of M with theM1 is considered stable or permanent.

Cash Balance Theory

• price level is always really passive?• Is it true that the comparison between M with M1 is

always stable?• The fact is, that assumption is not always true. The

price level is not passive but enough to play animportant role in determining the volume of trade (T)

• Initiated by D.H. Robertson is basically an improvementof the Fisher Equation. If Fisher multiplying M with V sothat the same as P multiplied by T, then the cashbalance theory approach PT multiplying by a factor "k"equal to M.

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Cash Balance Theory

• Factor "k" shows how part of the total annual publicexpenditure needs to be saved in cash

• The background and theoretical assumptions used by thecash balance theory remains the same as the assumptionsused in the quantity theory of Irving Fisher

• Fisher theory Money “movement”• Cash Balance Dormant Money

M = k x P.T

Income Velocity Approach

• This theory was pioneered by Marshall ofCambridge University, so often called MarshallEquation

• Marshall connects the quantity of money inthe Gross National Product

• Marshall did not emphasize on the velocity ofmoney in a period, but on the part of the GNPwhich is manifested in cash

Income Velocity Approach

• M = Amount of money• k = Part of the GNP in the form of cash, so

this essentially equal to 1 / V• P = Price• Y = Real GNP

M=k.P.Y

Income Velocity Approach• Marshall did not use the volume of goods traded (T) as

a means of measuring the amount of output, but witha "Y" is to show the Real GNP

• In Quantity Theory by Irving Fisher and Cash BalanceTheory assumed that:– T is considered fixed because it is always considered to be

in a state of full employment– Velocity is also considered to be relatively fixed, unless

there is a significant change in habits• As a result of these two assumptions is that the money

supply only affect currency prices proportionately andcan not affect real output