Essay on the Uses and Importance of Quantity Theory of Money (QTM) and Income Theroy of Money (ITM)

ADVERTISEMENTS:

A meritorious point of the income-expenditure approach is that it integrates the general theory of value with the theory of money as against the artificial dichotomy of the quantity theory in vogue, by interlinking all changes in the price level to changes.

Secondly, the QTM is somewhat unrealistic as it is based on the assumption of full-employment. The ITM adopts a more realistic approach in showing effects of changes in money on income and prices under the equilibrium conditions of less than full-employment.

Again, as Crowther points out, the savings and investment theory explains analytically many things about the behaviour of money that the quantity theory cannot.

ADVERTISEMENTS:

It clearly explains why it is that ordinarily a shortage of money can always produce a crisis in prosperity, but a plentiful supply of money cannot overcome a depression.

The theory holds that to effectuate revival, investment must exceed saving. Thus, the strategic variable is investment and not the quantity of money. On account of the expansion of the supply of money, interest rates may fall but investment will not rise unless the marginal efficiency of capital is revived.

The rate of investment depends upon businessmen’s expectation of profit, which in technical jargon, is termed as the marginal efficiency of capital. In a depression period, when the marginal efficiency of capital is low, a mere increase in money supply will be ineffective in pushing up the price level, and recovery will not start.

On the other hand, inadequacy of money can stop a boom. In a boom period, if there is shortage of money supply or bank credit or loan-able funds for investment become scarce, the rate of interest would rise, people would save more, and investment would fall due to lack of funds and rising interest rates and collapse of marginal efficiency of capital due to demand deficiency.

ADVERTISEMENTS:

When the boom ends, income declines as investment falls back and saving exceeds investment.

The ITM the saving and investment approach also sheds some light on the phenomenon of the velocity of circulation of money which has remained as a mysterious factor in all the versions of QTM.

The saving and investment theory reveals that when people save money and keep cash balances, it means that they are holding more of their wealth as liquid assets and when they invest, it implies that they are converting their cash balances, into durable goods.

Thus, when savings exceeds investment, people’s demand for money rises, so the velocity of circulation, accordingly, falls. And, if the quantity of money increases in such a situation, it may be held as money balance instead of being spent on investment.

ADVERTISEMENTS:

This explains the puzzling phenomenon that when money supply is increased at the bottom of a depression, it sometimes has no effect on the level of spending, so that in Fisherian terminology, V goes down as rapidly as M goes up, leaving MV unchanged.

On the other hand, velocity of circulation rises when investment exceeds saving. Thus, the income theory succeeds in explaining what the quantity theory does not, namely, why the velocity of circulation changes in the economy from time to time.

Even K, in the Cambridge equation which is, in fact, the reciprocal of V, only implies that the velocity of circulation depends upon the proportion of its wealth that the community wants to keep in the form of money or cash-balances (K).

Furthermore, the saving and investment theory indicates that the effect of a given change in the quantity of money on the price level is not a simple cause- and-effect relationship, as the quantity theory assumed, but a most complex chain reaction.

ADVERTISEMENTS:

The change in money supply may affect the rate of interest first, which, in its turn, brings about changes in the relationship between saving and investment, which in turn influences the level of prices.

If savings are in excess of investment, then prices will tend to fall below their equilibrium level. And, if savings are less than investment, prices will tend to rise above their equilibrium level.

The QTM holds M (the quantity of money) to be the only active and forceful causal factor. The ITM shows that the saving-investment relationships and their reactions are more causal and forceful than M.

Nonetheless, in the income theory, the relationship between saving and investment, as analysed, pertains only to the short-period fluctuations of employment and of prices.

ADVERTISEMENTS:

In the long-run phenomena, at full-employment stage, the quantity theory has its role to play. It has been admitted that prices can rise in a boom period, without any corresponding proportional expansion in supply of money but there cannot be a permanently higher level of prices without the support of permanently larger expansion in money supply.

Here comes the recognition of the age-old quantity theory of money. Thus, the income-expenditure approach does not invalidate the quantity theory but, instead, uncovers the underlying forces that generate changes, which the equations of the QTM merely record.

In fact, the ITM supplements and does not supplant the QTM. To quote Crowther, thus: “The Quantity Theory of Money explains, as it were, the average level of the sea; the saving and investment theory explains the violence of the tides.”

In fine, it may be said that both these theories QTM as well as ITM must be put in a set in order to understand the problem of value of money and price level, in the short run and long run, and design a suitable monetary policy, from time to time.

Web Analytics
Kata Mutiara Kata Kata Mutiara Kata Kata Lucu Kata Mutiara Makanan Sehat Resep Masakan Kata Motivasi obat perangsang wanita