Developed by the classical economists in the nineteenth and early twentieth centuries The quantity theory of money is a theory of how the nominal value of aggregate income is determined. Because it also tells us how much money is held for a given amount of aggregate income, it is a theory of the demand for the money. The most important feature of this theory is that suggests that interest rates have no effect on the demand for money. Money is neutrality hasn’t any effect on the economic variables expect the general level of price. That supposed: o The stability of the transaction. o The neutrality of the interest rates. o The neutrality of money. o The stability of GDP.
Velocity of Money and the Equation of Exchange
The clearest exposition of the classical theory approach is found in the work of the American economist Irving Fisher published in 1911. Fisher wanted to examine the link between: o The total quantity of money M(the money supply) and o The total amount of spending on final goods and services produced in the economy P x Y where P is the price level and Y is aggregate output (income). (Total spending P x Y is also thought of as aggregate nominal income for the economy or as nominal GDP). The concept that provides the link between M and P x Y is called velocity of money the average number of times per year (turnover) that a dollar is spent in buying the total amount of goods and services produced in the economy. Velocity V is defined more precisely as total spending P x Y divided by the quantity of money (V = (P x Y) ÷ M). Equation of Exchange MxV=PxY The Equation of Exchange thus states that the quantity of money multiplied by the number of times that this money is spent in a given year must equal nominal income (the total nominal amount spent on goods and services in that year) Page 1 of 9 Demand for money: Another way of interpreting Fisher's quantity theory is in terms of the demand for money, the quantity of money that people want to hold. Md = k x PY Because k is constant, the level of transactions generated by a fixed level of PY determines the quantity of Md. The demand for money is not affected by interest rates. Fisher’s view that velocity is fairly constant in the short run, so that , transforms the equation of exchange into the quantity theory of money, which states that nominal income (spending) is determined solely by movements in the quantity of money M
Quantity Theory and the Price Level
Because the classical economists (including Fisher) thought that wages and prices were completely flexible, they believed that the level of aggregate output Y produced in the economy during normal times would remain at the full- employment level Classical economists relied on the quantity theory of money to explain movements in the price level. In their view, changes in the quantity of money lead to proportional changes in the price level.
Quantity Theory and Inflation
the quantity theory of inflation indicates that the inflation rate equals the growth rate of the money supply minus the growth rate of aggregate output. So the quantity theory of money reach to: Velocity fairly constant in short run Aggregate output at full-employment level Changes in money supply affect only the price level Movement in the price level results solely from change in the quantity of money.
Keynesian Theories of Money Demand
Keynes does not agree with the older quantity theorists that there is a direct and proportional relationship between quantity of money and prices. According to him, the effect of a change in the quantity of money on prices is indirect and non-proportional. This dichotomy between the relative price level (as determined by demand and supply of goods) and the absolute price level (as determined by demand and supply
Page 2 of 9 of money) arises from the failure of the classical monetary economists to integrate value theory with monetary theory. Consequently, changes in the money supply affect only the absolute price level but exercise no influence on the relative price level. Further, Keynes criticizes the classical theory of static equilibrium in which money is regarded as neutral and does not influence the economy’s real equilibrium relating to relative prices. According to him, the money influence in the economy. The Keynesian chain of causation between changes in the quantity of money and in prices is an indirect one through the rate of interest. So when the quantity of money is increased, its first impact is on the rate of interest which tends to fall. Given the marginal efficiency of capital, a fall in the rate of interest will increase the volume of investment. The increased investment will raise effective demand through the multiplier effect thereby increasing income, output and employment. The kind demand for money (Keynes’s): Keynes presented three motives behind the demand for money: the transactions motive, the precautionary motive, and the speculative motive. 1. Transactions Motive The demand for money for the purpose of transactions (relationship with income): keeps money to conduct daily transactions So Keynes initially accepted the quantity theory view that the transactions component is proportional to income. 2. Precautionary Motive The demand for money in order to reserve (relationship with income): keeps money to meet any unforeseen emergency circumstances or Keynes also recognized that people hold money as a cushion against unexpected wants. Keynes argued that the precautionary money balances people want to hold would also be proportional to income 3. Speculative Motive The demand for money for speculative purposes (relationship with interest rate): Keep money in order to seize or take advantage of any investment opportunity Keynes also believed people choose to hold money as a store of wealth, which he called the speculative motive
Page 3 of 9 Keynesian Liquidity trap Liquidity trap is a situation, described in Keynesian economics, in which injections of cash into the private banking system by a central bank fail to decrease interest rates and hence make monetary policy ineffective. A liquidity trap is caused when people hoard cash because they expect an adverse event such as deflation, insufficient aggregate demand, or war. Common characteristics of a liquidity trap are interest rates that are close to zero and fluctuations in the money supply that fail to translate into fluctuations in price levels.
Page 4 of 9 Chapter (6) Questions Multiple Choice Questions (MCQs) 1. The quantity theory of money is a theory of how a. the money supply is determined b. interest rates are determined c. the nominal value of aggregate income is determined d. the real value of aggregate income is determined 2. Because the quantity theory of money tells us how much money is held for a given amount of aggregate income, it is also a theory of a. interest-rate determination b. the demand for money c. exchange-rate determination d. the demand for assets 3. The average number of times that a dollar is spent in buying the total amount of final goods and services produced during a given time period is known as a. gross national product b. the spending multiplier c. the money multiplier. d. velocity. 4. The velocity of money is a. the average number of times that a dollar is spent in buying the total amount of final goods and services b. the ratio of the money stock to high-powered money c. the ratio of the money stock to interest rates d. the average number of times a dollar is spent in buying financial assets 5. If the money supply is $500 and nominal income is $3,000, the velocity of money is a. 1/60. b. 1/6. c. 6. d. 60. 6. If the money supply is $600 and nominal income is $3,000, the velocity of money is a. 1/50 b. 1/5 c. 5 d. 50 7. If the money supply is $500 and nominal income is $4,000, the velocity of money is a. 1/20 b. 1/8. c. 8. d. 20. 8. If the money supply is $600 and nominal income is $3,600, the velocity of money is a. 1/60 b. 1/6 c. 6 d. 60 9. If nominal GDP is $10 trillion, and the money supply is $2 trillion, velocity is a. 0.2 b. 5 c. 10 d. 20.
Page 5 of 9 10. If nominal GDP is $8 trillion, and the money supply is $2 trillion, velocity is a. 0.25. b. 4. c. 8. d. 16 11. If nominal GDP is $10 trillion, and velocity is 10, the money supply is a. $1 trillion b. $5 trillion c. $10 trillion d. $100 trillion 12. If the money supply is $2 trillion and velocity is 5, then nominal GDP is a. $1 trillion b. $2 trillion c. $5 trillion d. $10 trillion 13. If the money supply is $20 trillion and velocity is 2, then nominal GDP is a. $2 trillion b. $10 trillion. c. $20 trillion d. $40 trillion 14. Velocity is defined as a. P + M + Y. b. (P × M)/Y. c. (Y × M)/P. d. (P × Y)/M. 15. The velocity of money is defined as a. real GDP divided by the money supply b. nominal GDP divided by the money supply c. real GDP times the money supply d. nominal GDP times the money supply 16. The equation of exchange states that the quantity of money multiplied by the number of times this money is spent in a given year must equal a. nominal income b. real income c. real gross national product d. velocity. 17. In the equation of exchange, the concept that provides the link between M and PY is called a. the velocity of money b. aggregate demand c. aggregate supply d. the money multiplier 18. The equation of exchange is a. M × P = V × Y. b. M + V = P + Y. c. M + Y = V + P. d. M × V = P ×Y. 19. Irving Fisher took the view that the institutional features of the economy which affect velocity change _____ over time so that velocity will be fairly _____ in the short run. a. rapidly; erratic b. rapidly; stable c. slowly; stable d. slowly; erratic
Page 6 of 9 20. In Irving Fisher’s quantity theory of money, velocity was determined by a. interest rates b. real GDP c. the institutions in an economy that affect individuals’ transactions. d. the price level 21. The classical economistsʹ conclusion that nominal income is determined by movements in the money supply rested on their belief that _____ could be treated as _____ in the short run a. velocity; constant b. velocity; variable c. money; constant d. money; variable 22. The view that velocity is constant in the short run transforms the equation of exchange into the quantity theory of money. According to the quantity theory of money, when the money supply doubles a. velocity falls by 50 percent b. velocity doubles c. nominal incomes falls by 50 percent d. nominal income doubles 23. Cutting the money supply by one-third is predicted by the quantity theory of money cause a. A sharp decline in real output of one-third in the short run, and a fall in the price level by one-third in the long run b. a decline in real output by one-third c. a decline in output by one-sixth, and a decline in the price level of one-sixth d. a decline in the price level by one-third 24. The classical economists believed that if the quantity of money doubled a. output would double b. prices would fall c. prices would double d. prices would remain constant 25. The classical economists’ contention that prices double when the money supply doubles is predicated on the belief that in the short run velocity is _____ and real GDP is _____. a. constant; constant b. constant; variable c. variable; variable d. variable; constant 26. For the classical economists, the quantity theory of money provided an explanation of movements in the price level. Movements in the price level result a. solely from changes in the quantity of money b. primarily from changes in the quantity of money c. only partially from changes in the quantity of money d. from changes in factors other than the quantity of money 27. If initially the money supply is $1 trillion, velocity is 5, the price level is 1, and real GDP is $5 trillion, an increase in the money supply to $2 trillion a. increases real GDP to $10 trillion. b. causes velocity to fall to 2.5. c. increases the price level to 2 d. increases the price level to 2 and velocity to 10. 28. If initially the money supply is $2 trillion, velocity is 5, the price level is 2, and real GDP is $5 trillion, a fall in the money supply to $1 trillion a. reduces real GDP to $2.5 trillion. b. causes velocity to rise to 10 c. decreases the price level to 1. d. decreases the price level to 1 and decreases velocity to 2.5.
Page 7 of 9 29. According to the quantity theory of money demand, a. an increase in interest rates will cause the demand for money to fall. b. a decrease in interest rates will cause the demand for money to increase c. interest rates have no effect on the demand for money. d. An increase in money will cause the demand for money to fall 30. Fisher’s quantity theory of money suggests that the demand for money is purely a function of _____ , and _____ no effect on the demand for money a. income; interest rates have b. interest rates; income has c. government spending; interest rates have d. expectations; income has 31. _____ quantity theory of money suggests that the demand for money is purely a function of income, and interest rates have no effect on the demand for money a. Keynes’s b. Fisher’s c. Friedman’s d. Tobin’s 32. Irving Fisher’s view that velocity is fairly constant in the short run transforms the equation of exchange into the a. Friedman’s theory of income determination b. quantity theory of money c. Keynesian theory of income determination d. monetary theory of income determination 33. The Keynesian theory of money demand emphasizes the importance of a. a constant velocity b. irrational behavior on the part of some economic agents c. interest rates on the demand for money d. expectations. 34. Keynes hypothesized that the transactions component of money demand was primarily determined by the level of a. interest rates. b. velocity. c. income. d. stock market prices 35. Keynes argued that the transactions component of the demand for money was primarily determined by the level of people’s ___, which he believed were proportional to _____. a. transactions; income b. transactions; age c. incomes; wealth d. incomes; age 36. Keynes hypothesized that the precautionary component of money demand was primarily determined by the level of a. interest rates. b. velocity. c. income. d. stock market prices 37. Keynes argued that the precautionary component of the demand for money was primarily determined by the level of people’s __, which he believed were proportional to ___. a. incomes; wealth b. incomes; age c. transactions; income d. transactions; age
Page 8 of 9 38. The demand for money as a cushion against unexpected contingencies is called the a. transactions motive b. precautionary motive. c. insurance motive d. speculative motive. 39. Keynes hypothesized that the speculative component of money demand was primarily determined by the level of a. interest rates b. velocity. c. income. d. stock market prices 40. Of the three motives for holding money suggested by Keynes, which did he believe to be the most sensitive to interest rates? a. The transactions motive b. The precautionary motive c. The speculative motive d. The altruistic motive.
# Ans. # Ans. # Ans. # Ans. # Ans.
1 C 9 B 17 A 25 A 33 C 2 B 10 B 18 D 26 A 34 C 3 D 11 A 19 C 27 C 35 A 4 A 12 D 20 C 28 C 36 C 5 C 13 D 21 A 29 C 37 C 6 C 14 D 22 D 30 A 38 B 7 C 15 B 23 D 31 B 39 A 8 C 16 A 24 C 32 B 40 C
