How is the general price level determined?
Why does price
level change? Classical or pre- Keynesian economists answered all
these questions in terms of quantity theory of money.
In its simplest form, it states that the general price level (P) in an
economy is directly dependent on the money supply (M);
P = f(M)
If M doubles, P will double. If M is reduced to half, P will decline by
the same amount. This is the essence of the quantity theory of money.
Though the theory was first stated in 1586, it received its full-fledged
popularity at the hands of Irving Fisher in 1911. Later, an alternative
approach was given by a group of Cambridge economists. However,
the basic conclusion of these two theories is same price level varies
directly with and proportionally to money supply.
Assumptions:
The classical quantity theory of money is based on two fundamental
assumptions: First is the operation of Say’s Law of Market. Say’s law
states that, “Supply creates its own demand.” This means that the sum
of values of all goods produced is equivalent to the sum of values of all
goods bought.
Thus, by definition, there cannot be deficiency of demand or under
utilization of resources. There will always be full employment in the
economy. Second is the assumption of full employment that follows
from the Say’s Law.
Quantity Theory of Money— Fisher’s Version:
Like the price of a commodity, value of money is determined by the
supply of money and demand for money. In his theory of demand for
money, Fisher attached emphasis on the use of money as a medium of
exchange. In other words, money is demanded for transaction
purposes.
As a truism, in a given time period, total money expenditure is equal to
the total value of goods traded in the economy. In other words,
national expenditure, i.e., the value of money, must be identically
equal to national income or total value of the goods for which money is
exchanged, i.e.,
MV = ∑ piqj = PT ….(4.1)
Where,
M = total stock of money in an economy;
V = velocity of circulation of money, that is, the number of times a unit
of money changes its hand;
Pi = prices of individual goods;
∑P = p1q1 + p2q2 + … + pnqn are the prices and outputs of all individual
goods;
qi = quantities of individual goods transacted;
P = average or general price level or index of prices;
T = total volume of goods transacted or index of physical volume of
transactions.
This equation is an identity that always holds true: It tells us that the
total stock of money used for transactions must equal to the value of
goods sold in the economy. In this equation, supply of money consists
of nominal quantity of money multiplied by the velocity of circulation.
The average number of times that a unit of money changes its hand is
called the velocity of circulation of money. The concept that provides
the link between M and P x T is also called the velocity of money. V is,
thus, defined as total expenditure, P x T, divided by the amount of
money, M, i.e.,
V = P x T/M
If P x T in a year is Rs. 5 crore and the quantity of money is Rs. 1 crore
then V = 5. This means that a unit of money is spent 5 times in buying
goods and services in the economy. Thus, the supply of money or the
total expenditure on national income is MV. On the other hand, total
value of all transactions or money demand comprises P multiplied by
T.
Fisher assumed fixity in V in the short run. V is determined by (i) the
payment habits of the people, (ii) the nature of the banking system,
and (iii) general factors (e.g., density of population, rapidity of
transportation). As far as T is concerned, Say’s Law suggests that it
would remain fixed because of full employment.
With V and T constant, the above identity is modified as:
MV = PT … (4.2)
or P = V/T x M … (4.3)
Where the bar sign over the heads of ‘V’ and ‘T’ indicates that these
two are fixed. It now follows that an increase in M leads to an equi-
proportional increase in P.
The stock of money, thus, determines the price level. People hold
money more than their need for transactions when money supply in-
creases. Holding of money is useless. So they spend money. This
additional expenditure, given full employment, raises the price level.
Obviously, a rise in the price level means an increase in the value of
transactions and, hence, demand for money rises. The process will
continue until the equality between demand for and supply of money
is reestablished.
Fisher’s cash transaction version can be extended by including bank
deposits in the definition of money supply. Now money supply
comprises not only legal tender money, M but also bank money, M’.
This bank money has also a stable velocity of circulation, V’.
Thus the above equation can be written as:
Assuming V, V’, T and the ratio of M and M’ constant, an increase in M
and M’, say by 5 p.c., will cause P to rise also by the same percentage.
It is, however, not easier to measure the number of transactions T. Let
us replace T by Y. Thus P. Y is the nominal income or output where Y
is the total income. Now the quantity theory equation becomes: PY =
MV. This is known as the ‘income version’ of quantity theory of
money.
Quantity Theory of Money: Cambridge Version:
An alternative version, known as cash balance version, was developed
by a group of Cambridge economists like Pigou, Marshall, Robertson
and Keynes in the early 1900s. These economists argue that money
acts both as a store of wealth and a medium of exchange. Here, by cash
balance and money balance we mean the amount of money that people
want to hold rather than savings.
According to Cambridge economists, people wish to hold cash to
finance transactions and for security against unforeseen needs. They
also suggested that an individual’s demand for cash or money balances
is proportional to his income. Obviously, larger the incomes of the
individual, greater is the demand for cash or money balances.
Thus, the demand for cash balances is specified by:
Md = kPY …(4.6)
where Y is the physical level of aggregate or national output, P is the
average price and k is the proportion of national output or income that
people want to hold. Let us assume that the supply of money, M S’ is
determined by the monetary authority, i.e.,
MS = M …(4.7)
Equilibrium requires that the supply of money must equal the demand
for money, or
K and Y are determined independently of the money supply. With k
constant given by the transaction demand for money and Y constant
because of full employment, increase or decrease in money supply
leads to a proportional increase and decrease in price level. This con-
clusion holds for Fisherian version also. Note that Cambridge ‘k’ and
Fisherian V are reciprocals of one another, that is, 1/k is the same as V
in Fisher’s equation.
The classical relationship between money supply and price level can be
illustrated in terms of Fig. 4.1. This diagram is interesting in the sense
that it first establishes the relationship between money supply and
national output or national income below the full employment stage
(YF). For this relationship, the origin ‘O’ is important.
Now the relationship between money supply and price level after the
full employment stage can be established assuming O’ as the origin.
Before the attainment of full employment state (YF), an increase in
money supply (from OM1 to OM2 and to OYF) causes national income
(shown by the steep output curve) to rise more rapidly than the price
level.
By utilizing its resources efficiently and fully, an economy can increase
its output level by increasing the volume of investment consequent
upon an increase in money supply. Since there is a limit to output
expansion due to full employment (i.e., beyond which output will not
increase), an increase in money supply from (M3 to M4) will cause price
level to rise from (P3 to P4) proportionally (shown in the upper panel).
For stability in price level money supply should grow in proportion to
increases in output.
3. Limitations:
This theory has been criticized on several grounds:
(i) Inoperative below Full Employment:
It is alleged that the quantity theory of money comes into its own only
during period of full employment of resources. Assuming constancy in
V, V’, T, Y, etc., a change in money supply will bring about a change in
price level. During the period of full employment, T or Y remains
unchanged. During such a time, even if money supply rises, T or Y will
not change.
On the other hand, price level will rise. But, in reality, full employment
of resources is a rare possibility. What we find in reality is unem-
ployment or underemployment of resources. During
underemployment an increase in money supply will tend to raise
output level and, hence, T, but not P. So, quantity theory of money
breaks down when resources remain at full employment.
(ii) V, T, etc., do not Remain Fixed:
Secondly, in a dynamic economy V, V’, T, the ratio of M to M’ never
remain constant. In such an economy, a change in any of the variables
may cause a change in price level, even if money supply does not
change. In this sense, these are not independent variables, although
the authors of this theory assumed quantity of money as independent
of other elements of the equation.
(iii) It is Identity, That is, Always True:
Thirdly, Fisher’s equation is an identity. MV and PT are always equal.
In fact, the quantity theory of money is a hypothesis and not an
identity which is always true.
(iv) Aggregate Demand/Expenditure, and not M, Influences
Price Level:
Fourthly, Keynes argued that price level in an economy is not
influenced by money supply. The important determinant of money
supply is the income level and the total expenditure of the country.
According to Keynes, an increase in money supply is tantamount to an
increase in effective demand.
After attaining the stage of full employment, an increase in effective
demand which is the sum of consumption expenditure, investment
expenditure and government expenditure (i.e., C + I + G) will raise the
price level, but not proportionately.
(v) Too much Emphasis on Money Supply:
Fifthly, change in price level is caused by various factors, besides
money supply. For example, an increase in cost of production has an
important bearing on the price level. For instance, an increase in wage
rate following a revision in the pay scale of employees or an increase in
the price of raw materials (say, hike in the price of petroleum
products) will definitely push the price level up, whether the economy
stays on or below the full employment level. The quantity theory
attaches too much importance on money supply.
(vi) M Influences P via Interest Rate:
Sixthly, the classical theory establishes a direct and proportional
relationship between money supply and price level. Critics say that the
relationship is not a direct one. Fisher ignored the influence of the rate
of interest on the price level. Supply of bank money or credit money is
influenced largely by the interest rate.
It is argued that the increase in money supply first affects the rate of
interest which influences total output and price level in the ultimate
analysis. The casual relationship is: Change in the stock of money →
change in interest rate change in investment → change in income,
employment and output → change in general prices.
Conclusion:
Despite these criticisms, the quantity theory of money has certain
merits. Whenever money supply rose abnormally in the past in an
economy, inflationary situation developed there. May not be the
relationship a proportional one, but excessive increase in money
supply leads to inflation.
In the 1950s, Milton Friedman came out with a thesis that ‘inflation is
always and everywhere a monetary phenomenon’. This Friedmanian
words are enough to establish the essence of quantity theory of money
inflation is largely caused by the excessive growth of money supply
and by nothing else.
http://article.sapub.org/10.5923.j.economics.20140403.01.html
