QUANTITY THEORY OF MONEY

Developed by the classical economists in the nineteenth and early twentieth century’s, 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 also a theory of the demand for money. The most important feature of this theory is that it suggests that interest rates have no effect on the demand for money.

Velocity of Money and Equation of Exchange. The clearest exposition of the classical quantity theory approach is found in the work of the American economist Irving Fisher, in his influential book The Purchasing Power of Money, published in 1911. Fisher wanted to examine the link between the total quantity of money Omega Speedmaster Replica M (the money supply) and 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 the velocity of money (often reduced simply to velocity), the rate of turnover of money, that is, the average number of times per year 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 84 by the quantity of money
M: = (P?Y)/M
If, for example, nominal GDP (P x Y) in a year is $5 trillion and the quantity of money is $1 trillion, velocity is 5, meaning that the average dollar bill is spent five times in purchasing final goods and services in the economy.

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 be equal to nominal income (the total nominal amount spent on goods and services in that year).l

As it stands, Equation 2 is nothing more than an identity—a relationship that is true by definition, it does not tell us, for instance, that Omega Replica when the money supply M changes, nominal income (P x F) changes in the same direction; a rise in M, for example, could be offset by a fall in V that leaves M x V (and therefore P x F) unchanged. To convert the equation of exchange (an identity) into a theory of how nominal income is determined requires an understanding of the factors that determine velocity.

Irving Fisher reasoned that velocity is determined by the institutions in an economy that affect the way individuals conduct transactions. If people use charge accounts and credit cards to conduct their transactions and consequently use money less often when making purchases, less money is required to conduct the transactions generated by nominal income (Mo, relative to Px Y), and velocity (P x Y)/M will increase. Conversely, if it is more convenient for purchases to be paid for with cash or checks (both of which are money), more money is used to conduct the transactions generated by the same level of nominal income, and velocity will fall. Fisher took the Omega Replica Watches view that the institutional and technological features of the economy would affect velocity only slowly over time, so velocity would normally be reasonably constant in the short run.