Quantity theory of money is a classical theory of money demand, why? You will understand the concept of money demand, reasons to hold money, classical theory of money demand, implications and criticism of theory after reading this article. But before, we advise you to read the full article about quantity theory of money.
Concept of Money Demand
Although people do not hold idle cash balance, they hold some quantity of money for the transaction purpose. In fact, the demand for money is the quantity of money that people want to hold. However, in wider sense, demand for money is the monetary assets that consist of cash balance along with checking accounts that people want to hold in their portfolios.
Why people hold money? The reason is that they want to settle the financial transactions. In classical sense, people want to hold money only for the transaction purpose. That means demand for money does not depend on interest rate, it depends only on volume of transaction. This way, money only works as the medium of exchange, but not a store of value in classical viewpoint. To sum up, the more transaction to settle, the more money people want to hold.
Classical Theory of Money Demand
Classical theory of money demand refers to the quantity theory of money. Now, let us start with the familiar equation of exchange, MV = Py. We take this equation of exchange as given from the quantity theory of money.
The quantity theory of money links total money supply (M) to the total spending on goods and services (Py) in the economy. Velocity of money, V, is the concept that works as the link between total money supply and total spending.
Let’s rewrite equation of exchange dividing on both sides by V as,
M = 1/V . Py …… (i)
Note that ‘M’ on the left hand side of equation (i) represents the total money supply in an economy. In addition, when money market is in equilibrium, money supply (M) equals money demand (Md) i.e.
M = Md ….. (ii)
Now, considering money market equilibrium, we can derive money demand function by replacing M by Md in equation (i) as, Md = 1/V (Py). Since, V is assumed to be constant (why? You will see later.), we can replace 1/V with some constant, k as
Md = k . Py ….. (iii)
In fact, the equation (iii) is the money demand function, the another way of interpreting Fisher’s equation of exchange. The equation tells us that certain portion of nominal spending (Py) is the amount of money people want to hold (Md). This is why the quantity theory of money is the theory of money demand.
Classical Money Demand Function in Real Terms
Dividing on both sides by P the equation (iii), we get the real money demand function as,
Md/P = k. y ….. (iv) .
The equation (iv) tells us about the real money balance, money balance in terms of goods and services that people want hold is proportional to real income.
Why Constant Velocity (V)?
In the equation of exchange MV = Py, a fall in V could offset a rise in M; thereby leaving MV and Py unchanged. Here, question arise to the stability of velocity: Is V stable?
Advancement in institutional (spending habits) and technological features (payment technology advances) may reduce the need for holding money balance. For example, increasing usages of bank cards and online payment systems are likely to reduce the demand for money relative to income. Similarly, spending habits of public may significantly change to cause the velocity of money.
However, Fisher’s assumption is that institutional and technological features change very gradually over time. Thus, velocity of money remains fairly constant over long period of time.
The constant velocity refers to the stable money demand function, which is prerequisite for the effective monetary management. Depending upon the stability of money demand, central monetary authority either target money supply or interest rate. If money demand is stable, definitely the target will be on money supply. That means tuning the money supply is to tune price and income.
Implications of Classical Theory of Money Demand
The quantity of money that the people wants to hold is proportional to nominal income. That means the demand for money is determined by level of income.
Constant velocity of money implies the stable money demand function, which is the prerequisites for effective monetary policy to mange quantity of money. If money demand function is stable (V is constant), then the central bank should target money supply instead of interest rate.
According to quantity theory of money, quantity of money has directly proportional relationship to price level. This means quantity of money is fully reflected in the price level. Thus, there is neutrality of money. In other terms, quantity of money has to effect on real variable y of right side of equation (iv).
Criticism of Classical Theory of Money Demand
J. M. Keynes has proposed a different approach to demand for money, also called liquidity preference theory. According to him, demand for money is interest rate elastic; higher interest rate leads to lower demand for money due to the opportunity cost of holding money, which earns virtually no interest on Keynesian analysis.
Therefore, changes in the interest rate cause the velocity of money to change. That means the classical assumption of constant velocity of money no longer holds true in Keynesian theory of money demand.