The Classical Quantity theory of Money Demand

The  classical  quantity   theory  of money   demand   states  that,  keeping  the level of transactions  and velocity of money constant, the general price level of goods and services is determined by  the stock of  money  circulating  in  the  economy.

This theory   is illustrated    by Irving   fisher’s   equation of exchange which states that MV = PT

where;

M is the stock of money (money in circulation)

V is the velocity of money (that is, the number of times money changes hands)

P is the general price level

T is the level of transactions

From   the   equation   above,   assuming V and T constant,    the   stock   of money   (M)  is directly proportional to the general   price   level.   That  is  an  increase   money   supply   keeping   the  level   of transactions   and velocity  of money  constant  increases  the general  price  level of goods  and services  in the economy.  That is

The theory is based on the following assumptions;

1. Price is only affected by changes in money supply
2. There is full employment of resources in the economy
3. All money earned is spent on the consumption of goods and services
4. Money is only demanded for transaction motive.
5. Absence of barter trade
6. The volume of transactions is constant
7. The velocity of money in circulation is constant

Example

Given that in the economy, M = shs.300,000, V = 50, T = 300.  Calculate   the general price level.

Solution

MV=PT

Criticisms (Limitations) of the classical Quantity theory of money demand

The quantity theory of money is criticized on the following grounds;

1. The theory only  emphasizes  the  transaction  motive  of  holding   money  and  it  ignores   the precautionary   and speculative  motives  of money  demand.
2. It is just a truism and not a theory. It merely shows that the four variables M, V, P and T are related.
3. The theory   ignores   commodities    that   are transacted through barter trade as a system   of exchange.
4. The theory only explains the changes in the value of money but not how the value of money is determined.
5. The assumption that the velocity of money (V) and the level of transactions (T) are constant is unrealistic. This is because they are affected by the expenditure   behavior   and hoarding   habits of individuals.
6. It assumes a general price level which is unrealistic. This is because there may be a series of price levels of commodities in the economy.
7. The four variables M, V, P and T are not independent of one another as the theory   assumes. This is because a change in one induces a change in other variables.
8. If the country  has  many  unemployed  resources,  the  increase   in  money   supply   leads   to  an increase  in output  of goods and services  which  makes  the price  to fall or not to change  at all.
9. An increase in money supply may result into higher savings if the marginal propensity to save is high. This reduces the velocity of circulation   and prices may fall.
10. The theory ignores haggling as a method of price discrimination in the market. That is haggling between buyers and a seller to reach an agreeable price is not taken into account.
11. It does not take into account other causes of price increases (inflation) like cost push, break down of infrastructure etc.
12. It ignores influence of interest rate. The theory cannot be complete without mentioning interest as the major determinant   of money demand in the economy.
13. The theory ignores government   control  of prices  in  the  market   as  a  way  of  ensuring   price stability.
14. The theory does not take into account the demand for money. It only looks at money supply.