Some of the majors criticism against the QTM an appraisal are: 1. Constancy of V, 2. V’s Independence of M, 3. Erogeneity of M, 4. Lack of Transmission Mechanism, 5. Equilibrium Equation, 6. Other Influences on Y and 7. Real Output determined by Real-Sector Forces only.

The QTM is one of (he most venerable and well-known theories of Economics. It is also one of the simplest-looking. This simplicity is both its strength and weakness. It is its strength because it states the hypothesised relation between M and P (and between a change in M and the resulting change in P) most clearly and precisely, a statement which can be easily understood by the reader.

It is its weakness because the relation hypothesised is too clear and too precise and in the economic field such precise relations are not observed. Therefore, they are bound to raise doubts. Also, in their attempt to arrive at the simple and clear relation between M and P, the early quantity theorists simplified too much—broad judgements about economic phenomena, which, at best, are true only to a first order to approxima­tion, were assumed (for simplicity, no doubt) to hold true always.” This was bound to invite rejection of the QTM on various counts.

The experience of the Great Depression of 1929-33 and the publication of Keynes’s General Theory (1936) gave a severe blow to monetary theory built around the QTM. Interest in this theory was revived during the 1950s and thereafter mainly under the leadership of Milton Friedman who has given both a more sophisticated interpretation of the QTM than before and provided much empirical support to it.


Several other economists have followed Friedman’s lead, so that it is no longer unrespectable to lend qualified support to the theory. Yet there is no dearth of critics and of criticism of the QTM, some of which is either misplaced or based on misunderstanding of the theory. In this section we discuss briefly the main points of criticism as well as of defence of the QTM.

To conserve space, we shall not discuss separately the shortcom­ings of Fisher’s version and of the Cambridge version of the QTM . Therefore, in order to fix our object of appraisal, we choose the Cambridge Cash-Balances version of the QTM.

Modern QTM with several points of reformulation in theory but not so in empirical, work is difficult to appraise without going into an extended debate around the large amount of empirical work which has been done and is being done on the subject. Most of the criticism will be discussed with reference to the QTM as a theory of Y. But by now the reader must have understood that this criticism is equally applicable to the QTM as a theory of P as well. Additional criticism of the QTM as a theory of P will appear in the end as the final point of criticism.

The major points of criticism of the QTM are discussed below:


1. Constancy of V:

The most crucial assumption of the QTM is the constancy of V. In the Fisher version. V was interpreted as transac­tions velocity and taken to be determined by payments practices and other structural features of the economy influencing the use of money as the medium of exchange.

Since these factors were taken to be slow-moving. V was also assumed to be slow changing. More specifically, it was assumed to be independent of M or changes in M and also such endogenous variables as income, rate of interest, prices, etc. This has not been supported by empirical evidence which clearly shows that measured V (given by Y/M) is not a short-run constant. That being so, it is argued, the QTM cannot be accepted as a reliable theory for predicting short-run changes in Y.

That variations in V can do substantial damage to the QTM model can be easily explained.


For this, recall the QTM equation (12.12):

Y = V.M. (12.12)

∆Y= V. ∆M (12.13)

If both M and V are allowed to vary, changes in Y will be given by the following equation:


∆Y =V.∆M+ ∆V.M-t-∆V. ∆M, (12.16)

derived from equation Y = V.M. (12.12). The last term on the right-hand side of the above equation is the interaction (between AV and AM) term, which will go to zero as AV or AM goes to zero. If V is a constant (as assumed in the QTM), the last two terms on the right-hand side of equation ∆Y =V.∆M+ ∆V.M-t-∆V. ∆M, (12.16) will disappear and we shall get back the QTM equation ∆Y= V. ∆M (12.13). In the presence of non-zero ∆V, the other two terms will have to be reckoned with. Therefore, without knowing the value of ∆V we cannot say what ∆Y will be consequent on ∆M.

To explain and predict the behaviour of V, we need some theory of V. This theory is provided by the theory of the demand for money, once it is assumed that actual V = desired W (Vd), because the latter is simply the reciprocal of Md/Y, that is of the demand for money per rupee of income. Therefore, anything that raises Md per Re of Y will lower and so Vd and conversely anything that lowers Md (at the same Y) will raise Vd and so V. So, knowing the demand for money in an economy is of prime importance.

The simple demand function for money of the Cambridge Cash Balances theory directly yields constant V. Such a demand function for money may or may not obtain in an economy. Therefore, in theory at least, we must start with a more general demand function for money.


To recall briefly, the demand for money in the Keynesian theory, besides being an increasing function of income, is made also a decreasing function of the rate of interest. This turned out be a revolutionary development in monetary theory. It broke down the simplicity of the QTM, because, once an additional unknown in the form of the rate of interest (r) is introduced in the Md function, the money-market equilibrium condition that makes = cannot yield us the QTM equation Y = V.M. (12.12).

Instead, we get:

Md (Y,r) = M, (12.17)

which is one equation in two unknowns and hence cannot be used for determining the equilibrium value of either Y or r. This makes Keynes’ liquidity preference of the rate of interest equally invalid. A resolution of the problems raised by equation Md (Y,r) = M, (12.17) has been provided by Hicks (1937) through his IS—LM model. This resolution does further damage to the simple QTM. Since r is an endogenous variable (that is, a variable determined within the system) and is affected also by the real-sector forces (of, say, savings and investment), all the latter forces come to impinge on the determination of Y via r and Md.


Thereby even Y (nominal income) cannot be called a purely monetary phenomenon or we cannot say that changes in Y are determined only by changes in M or that ∆M affects only Y, as predicted by the QTM. It is this point of interaction between the monetary sector and the real sector in determining the equilibrium values of Y and r that was stressed by several monetary economists individually in their separate reviews of the monumental study, A Monetary History of the United States, 1867 -1960 by Friedman and Schwartz (1963).

If either the rates of interest did not vary or the sensitivity of the Md func­tion to observed changes in r was not significant, then the simple QTM of Y, in practical terms, was free, from the Keynesian criticism. Since, in actual experience, rates on interest have varied a good deal, the whole debate boils down to the r-sensitivity of Md.

Friedman (1959) in his statistical study of the demand for money in the USA over the period 1869-1957 had found r to be statistically insignificant. Several other economists have found fault with Friedman’s specifications and statistical methods and have produced their own estimates of the demand function for money for the USA which do show the demand for money to be r-sensitive. And the controversy continues.”

For India; we have already reported the state of empirical evidence on the demand for money, which does raise serious doubts about the statistical significance of the rate of interest for this demand (in India). In addition, it has also been found that the best estimate of the income-elasticity of demand for money is unity.

These two features of the demand for money in India lend special relevance to the simple QTM of Y for India. Yet the observed behaviour of V in India indicates clearly that it has not been a time-constant. It has varied significantly from one year to the next, but mostly in a cyclical manner (of variable periodicity) and without any long-run tendency in the upward or downward direction.

The significant feature is the flat trend in V, pointing towards long-run average constancy of V. This kind of empirical evidence suggests that the QTM model of Y can possibly be used fruitfully for only longer-term analysis of Y and not for short-term (year-to-year) analysis of Y. This is an important qualification or limitation of the QTM model of Y, which should be always borne in mind, while using this model for India.

2. V’s Independence of M:

The QTM (equation 12.12) assumes that V is independent of M. The assumption will come under strain if, as in Keynes’ theory, r changes as M changes and V (or Md) is r-responsive. This question of the responsiveness of V to changes in r. An additional circumstance of Vs dependence on changes, in M has been pointed out by monetarists themselves (see Cagan, 1956).

This arises under a situation of anticipated inflation. In Friedman’s specification of the demand for money the expected rate of change of prices acts as an opportunity cost of holding money. Cagan (1956) in his classic study. The Dynamics of Hyperinflation, had found the expected rate of change of prices as the sole explanatory variable for the “demand for money.

The sequence which breaks V’s independence of M then is the following: M→ P→ pe →V, where the dotted variables are proportionate rates of change per unit time of respective variables M. P, and Pe, and Pe stands for the expected P. This relation and the stability of P will be discussed in Appendix D. At this stage it may only be noted that the problem of any relation between V and M (not just M) becomes acute only when M is changing very fast.

3. Erogeneity of M:

In all statements of the QTM it is assumed that M is exogenously given—that M is policy-determined. Modern theory of money supply shows clearly that the supply of money (Ms) is an endogenous variable. This raises the possibility of changes in Ms occurring in response to ‘autonomous’ changes in P—changes in P that, for example, are occurring due to the operation of cost-push factors.

4. Lack of Transmission Mechanism:

Quite often the QTM is stated only as a truism, which, of course, is true export. Even when it is stated as a theory in ex ante terms, it is rarely supported by an explanation of the underlying transmission mechanism (or adjustment process) whereby AM comes to exert its influence on Y.

The explanation is appropriate for only the crude QTM. Admittedly, this is only a part of the adjustment process, the other part provided by Keynes’ monetary theory. Friedman as the leading quantity theorist of modern times admits both kinds of adjustment process.

5. Equilibrium Equation:

If the OTM equation at worst is a truism, at best it is an equilibrium equation for the money market, that is, it will be true only when the money market is in equilibrium. This is true, but not a special failing of the QTM alone, since most results in economic theory are derived through equilibrium analysis.

However, while applying these theories to practical situations, due allowance can be and should be made for possible lags in adjustment. Alternatively and more simply, we can say that the money-market equilibrium hypothesised in the QTM takes longer than a year (say, 5 years) to attain itself that the QTM is a longer-term and not a short-term theory.

6. Other Influences on Y:

The QTM gives a mono-variable explanation of changes in Y (or in money expenditure) in terms of autonomous changes in M (assuming real income y to be given by the real-sector forces). The Keynesian theory emphasises the role of autonomous expenditures and fiscal policy variables in the determin­ation of Y. No doubt, ∆ M and the Keynesian variables are not all that independent of each other as they are made out to be. But the two sets of variables are not identical either.

7. Real Output determined by Real-Sector Forces only:

The QTM of F assumes explicitly that the real output (y) is determined by the real sector forces of factor supplies and technology on the supply side— that this supply creates its own demand (Say’s Law). Keynes (1936) had revolted against this notion and emphasised the importance of aggregate demand in the determination of y in a world where the real and the monetary forces interact with each other.

The point is generally well taken now even by the so-called monetarists (Friedman and his followers). But as yet we do not have a trouble-free macro model which gives a simultaneous determination of P and y. However, the QTM does come into its own (with its other failings), once the object of analysis is the problem of inflation and the deficiency of aggregate demand can be assumed away.