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Explain the quantity Demand Theory of Money

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The theory traces the connection between changes in the amount of money in circulation and changes in general price level. Its originally can be traced in 16 century by John Lacke. Later it was improved by Irving Fisher. According to this theory there is a direct relationship between supply of money and the level of prices. The demand for money depends on the level of transactions, which in tern depend on the level of income. If the quantity of money doubled, price would also double.
P = 8 M
P = priced
8 = Constant
M = Money stock / supply

Irving Fisher developed this theory to what is known as the equation of exchange.
MV = PT
M = Money supply
V = Money velocity of circulation of money
P = Price (average)/general price levels
T = Index measuring the volume of transactions in the economy/number of
transactions taking place in the period concerned.

Assumptions
(i) Proportion of change in money to money demand is constant
(ii) Demand for money is proportional to the volume of transactions
(iii) The theory is applicable in the long run
Transaction is defined as the exchange of commodities for money. The equation as the stated, it?s a tautology (identity) for it must be true MV and PT at two ways of looking at the same thing. When a commodity is purchased in money economy two things happen:-
a) The commodity passes from the seller to the buyer (PT)
b) Money passes from the from buyer to seller (MV)
Hence to get the total value under transaction we can trace the movement of commodities or the movement of money. We might then say MV represents the money paid by the consumers and received by procedures and PT is the value of goods obtained or supplied
in exchange for money during the year.
Major assumption of Fisher Quality Theory of money is that V (velocity) of money is constant because it depends on institutional characteristics of an economy at particular time such as the frequency at which people are paid. Money velocity also depends on technology (modern banking). Money velocity is roughly constant. However price P varies in proportion with to money supply M.

Weakness
(i) Keynes so a major weakness of the theory in that V and T would not vary only within narrow limits. There might be a disequilibrium in which transactions T remained at a level far below full employment.
(ii) Money velocity might fluctuate considerably within a short time because of say loss confidence by people holding idle money rather than undertaking business venture or holding non risky assets.
(iii) The quality theory of money can only hold if the velocity of money is stable or at least predictable. Otherwise the equations of exchange cannot be used predict, the effect of charge in money supply on nominal income. In Fisher?s analysis it?s the function of money as a medium of exchange that is emphasized. Money is not intrinsic a source of utility but is useful for undertaking transactions. The amount of money that an economy needs to facilitate transactions can be regarded as bearing a fixed technical relationship to the level of money transactions.

Wilfykil answered the question on March 8, 2019 at 10:28

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