Quantity Theory of Money

Quantity Theory of money
 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
income, it is also a theory of the demand for money.
 Intuitively, people want to hold a certain amount of cash because it is by
definition the most liquid asset in the economy. It can be exchanged for
goods at no cost other than the opportunity cost of holding a less liquid
income–generating asset instead. When interest rates are low (high), so is the
opportunity cost, so people hold more (less) cash. Similarly, when inflation
is low (high), people are more (less) likely to hold assets, like cash, that lose
purchasing power.
 People hold money for transection purposes.
 The simplest form of quantity theory of money is based on equation of
exchange given by Irving Fisher: which relate quantity of nominal income to
money and velocity of money.
MV=PY
 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).
 As it stands, Equation is nothing more than an identity—a relationship that
is true by definition.
 It does not tell us, for instance, that when the money supply M changes,
nominal income (P * Y) changes in the same direction; a rise in M, for
example, could be offset by a fall in V that leaves M * V (and therefore P *
Y) 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.
Determinants of 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,
as they can today, and consequently use money less often when making
purchases, less money is required to conduct the transactions generated by
nominal income (M falls relative to P * Y), and velocity (P * Y)>M will
increase.
 Conversely, if it is more convenient for purchases to be paid for with cash,
checks, or debit cards (all 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 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.
TOBIN MODEL
Transaction theories emphasize the role of money as a medium of exchange.
According to the transaction theory, money is a dominated asset people hold
money unlike other assets, to make purchases.
Keynes assumed Transaction and Precautionary DM = f(Y), so changes in interest
rate has no impact on them.
But Baumol showed that rate of interest also affects Transaction motive for
holding money. -- Holding cash in hand gives high liquidity. But there is loss of
interest as the money is not deposited in a bank. Therefore rate of interest also
affects Transaction Demand for Money.
Baumol model describes money demand in terms of a trade off between liquidity
and rate of return.
Assume that consumer can keep his income in the form of either cash in hand or in
savings account deposits. Cash pays no nominal interest. The savings account pays
interest rate i, this is the opportunity cost of holding cash.
Consumer’s choice: The consumer has to decide between keeping cash (liquidity)
but no interest, and putting it in a saving deposit – earns interest but less liquid. If
he keeps in savings deposit, he has to spend time and money to go to the bank to
withdraw cash. This is the opportunity cost of keeping money in the bank.
The consumer has to decide on the optimum allocation of his funds – between cash
and savings deposits.
According to Tobin, individuals show “Risk Aversion”. They prefer less risk to
more risk at a given rate of interest. Also, they are uncertain about the future rate
of interest
Money has both cost and benefit. Cost is the low rate of return and benefit is that, it
makes transactions more convenient.
So people decide how much money to hold by trading off these costs and benefits.
Baumol-Tobin was not satisfied with Keynes treatment of demand for money so he
developed the model of cash management in 1950 in which he explained the costs
and benefits of holding money.
Baumol-Tobin model shows that Transection demand for money depends

positively on the income level and negatively on the interest rate. This model is
explained in terms of assets. An individual holds portfolio for monetary assets
(currency and checking account) and non-monetary assets (stocks and bonds).
The optimum amount of asset he can hold will depend on the cost
considerations:
(i) Interest forgone on the cash balance held, and
(ii) Cost of acquiring bonds and converting them into cash, i.e., cost of brokerage.
People hold money in cash for convenience. When people hold money they incur
both benefit and cost. Benefit is the convenience which they get by avoiding
making a trip to the bank every time they wish to buy something. But the cost of
this convenience is the forgone interest which they would have earned if they had
deposited the money in the saving accounts. There is, thus, a trade off between
benefits and costs.
If one holds large amount of monetary assets, interest forgone will be very high but
if one holds less cash, then the interest forgone will be less but the transaction cost
of holding bonds, i.e., brokerage fee will be very high. To avoid these extreme
situations, people will hold both monetary and non-monetary assets to minimize
the cost.
For instance: Assume:
1. Price level is constant
2. Transactor has a given income. Real spending is constant over the year, that
is, an individual spends uniformly over the year.
3. Transaction funds can be held either in money or in interest yielding bonds.
4. Individual X makes ‘N’ trips to the bank.
5. Consumer plans to spend Rs. Y gradually over a year.
There are different possibilities:
1st Possibility:
Assume that consumer keeps all income in the form of cash. Then he only goes
once to the bank to withdraw cash (N = 1). He withdraws the entire amount Rs. Y
at the beginning of the year and spend it gradually. In one year, his average money
holdings = Y/2. By keeping all Y as cash, he loses interest.
2nd possibility
He makes two trips to the bank (N=2)
In the beginning of the year he withdraws Y/2 and spends it gradually over the first
six months.
Then he makes another trip and withdraws Y/2 to spend it over the next six
months.
Money holding over the year varies between Y/2 and Zero.
Since his average holdings are less, he forgoes less interest but the disadvantage
is that he had to make two trips to the bank.
3rd Possibility.
He makes N trips to the bank over the time period of one year. On each trip he
withdraws Y/N and spends gradually that is, uniformly over the following 1/N th
of the year.
Money holding varies between Y/N and zero
Average holding over the year is Y/2N (Fig. 22.3)
Thus, we find that greater is the N, less is the money the person holds on an
average and less is the interest he forgoes. But, as N increases, the inconvenience
of making frequent trips to the bank increases.
Model expressed in terms of Assets:
Let: (i) N → Number of trips made to the bank.
(ii) F → Cost of going to the bank or brokerage fee, that is, cost of transferring
non-monetary assets into monetary assets.
(iii) i → Rate of interest forgone, that is, opportunity cost of holding money.
Average amount of money held for any N is Y/2N.
... Forgone interest = iY/2N
... Total cost of making trips to the bank is FN
Total cost (TC) the individual bears is:
TC = Forgone interest + cost of trips
Equation (2) shows that : average cash holding is directly related to the income
level (Y) and (F) but indirectly related interest rate (i) If F is greater or Y is the
greater or i is lower (where Y is the expenditure), then the individual holds more
money, that is, demand for money depends positively on income (Y) and
negatively on the interest rate.
• As r rises, the opportunity cost of holding money rises and n increases. As n
increases,
money demand falls.
• As F increases, the cost of withdraws increases so n falls and money demand
rises.
• As Y rises, we must at each trip withdraw more cash. This does not affect the
total cost of withdraws, since we can withdraw any amount at cost δ. However, we
are holding more cash and thus the opportunity cost rises. So the solution is to
make a few more withdraws, so n increases. More purchases need to be made
which tends to increase M/P, but more withdraws tends to lower M/P. Overall the
first effect is stronger and M/P increases.
As the number of trips to the bank increases, the amount of interest forgone
decreases (Fig. 22.4)
... iY/2N curve is negatively sloped.
However, as the number of trips to the bank increases, the cost of visit increases.
Therefore, the FN curve is positively sloped.
TC curve is U shaped because it incorporates the transaction costs and the interest
forgone (i) Optimal number of visits is N*, because at N* the TC is minimum.
Thus, Baumol-Tobin model shows that demand for money is not only a function of
income level but also the interest rate.
Velocity of money
VELOCITY OF MONEY: how many times each dollar is spent in a given period.
CONSUMPTION VELOCITY OF MONEY: how many times each dollar is spent
on consumption.
 velocity is determined from the exchange equation:
MV =PY
 Velocity is thus:
Y
V=
M
P
Y
V=
M
P
Y
V=
Y
2N
V =2 N
2iY
V=
√ F
The BT model predicts velocity is not constant but is instead related to the interest
rate. As interest rates rise, money is spent more quickly as the cost of holding
money rises. This is consistent with the velocity data
Implication of the Model:
One implication of the Baumol–Tobin model is that any change in the fixed cost of
going to the bank F alters the money demand function—that is, it ⎯ changes the
quantity of money demanded for any given interest rate and income.
It is easy to imagine events that might influence this fixed cost. The spread of
automatic teller machines, for instance, reduces F by reducing the time it takes to
withdraw money. Similarly, the introduction of Internet banking reduces F by
making it easier to transfer funds among accounts. On the other hand, an increase
in real wages increases F by increasing the value of time. And an increase in
banking fees increases F directly. Thus, although the Baumol–Tobin model gives
us a very specific money demand function, it does not give us reason to believe
that this function will necessarily be stable over time.
If the fixed cost of going to the bank (F) changes, the money demand function
changes. Thus, although the model gives us a very specific money demand
function, it may not be necessarily stable over time.
Many economists have studied the data on money, income, and interest rates to
learn more about the money demand function. One purpose of these studies is to
estimate how money demand responds to changes in income and the interest rate.
Another purpose of the empirical studies is to test the theories of money demand.
The Baumol–Tobin model, for example, makes precise predictions for how income
and interest rates influence money demand. The model’s square-root formula
implies that the income elasticity of money demand is 1/2: a 10-percent increase in
income should lead to a 5-percent increase in the demand for real balances. It also
says that the interest elasticity of money demand is 1/2: a 10-percent increase in
the interest rate (say, from 10 percent to 11 percent) should lead to a 5-percent
decrease in the demand for real balances.
Most empirical studies of money demand do not confirm these predictions. They
find that the income elasticity of money demand is larger than 1/2 and that the
interest elasticity is smaller than 1/2. Thus, although the Baumol–Tobin model may
capture part of the story behind the money demand function, it is not completely
correct.
One possible explanation for the failure of the Baumol–Tobin model is that some
people may have less discretion over their money holdings than the model
assumes. For example, consider a person who must go to the bank once a week to
deposit her paycheck; while at the bank, she takes advantage of her visit to
withdraw the currency needed for the coming week. For this person, the number of
trips to the bank, N, does not respond to changes in expenditure or the interest rate.
Because N is fixed, average money holdings [which equals Y/(2N)] are
proportional to expenditure and insensitive to the interest rate.

Quantity Theory of Money

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Quantity Theory of money

 The quantity theory of money is a theory of how the nominal value of

Baumol-Tobin model shows that Transection demand for money depends

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