The income theory of money is superior to the quantity theory of money on the following grounds:
1. Integration of the Hieory of Value with the Theory of Money:
The quantity theory of money unnecessarily separated the theory of value (i.e., of relative prices) from the theory of money (i.e., of general price level) by holding that while relative prices are determined by the real factors like output, employment, etc., the general price level is influenced by the money supply.
The income theory of money integrates the two theories by demonstrating that the money supply influences prices via its effect on output and employment.
2. A Realistic Theory:
The income theory of money is a more realistic theory in two ways:
(i) While the quantity theory of money is based on the unrealistic assumption of full employment, the income theory seeks to analyse the changes in output and prices at less-than-full employment.
(ii) The quantity theory of money provides long terms analysis of price level. The income theory deals with the actual short term fluctuations in prices and economic activity and reveals the various forces influencing them.
Thus, Crowther has rightly remarked: The income theory “goes considerably near to the reality of things than the quantity theory. It reveals the fundamental tendencies of which the behaviour of money and prices is merely the surface of the symptom.”
3. Key Importance of Expenditure:
According to the quantity theory of money, changes in money supply leads directly to changes in the price level.
According to the income theory, the basic cause of changes in price level is the volume of expenditure (consumption and investment expenditure) and not the money supply changes in money income and the volume of expenditure leads to changes in output and employment which ultimately brings about changes in the prices.
Increase in expenditure increases output and prices and decrease in expenditure decreases output and prices.
4. Relation between Money Supply and Expenditure:
The quantity theory of money establishes a wrong causal relation between the money supply and the aggregate expenditure. According to the quantity theory, it is the quantity of money and its velocity which determines the aggregate expenditure.
According to the income theory, it is the flow of expenditure which determines the quantity of money and its velocity. An increase in the flow of expenditure of final goods and services will necessitate an increase either in money or in its velocity or in both.
It is like saying that if a man grows fat, he will require a larger belt. But, according to the quantity theory of money, if you first arrange a larger belt, you will in consequence of this action necessarily grow fat.
5. Limited Role of Money:
The income theory of money, however, denies an important role to the money supply. An increase in money supply can cause an increase in spending. But the income theory stresses the point that there is no direct route from quantity of money to the level of expenditure or income.
Whether increased money supply leads to an increase in expenditure depends upon many in between links such as, (a) the interest elasticity of the investment function, (b) the sensitiveness of the consumption function to shifts in the rate of interest, and (c) the interest elasticity of the liquidity preference function. Ultimately the role of money depends upon what part does money play in income determination.
6. Explanation of Trade Cycle:
The income theory of money has an advantage over the quantity theory of money because it is able to identify and analyse the factors which cause periodic fluctuations in prices, output and employment.
According to the income theory, business cycle is nothing but alternating expansion and contraction of national income and is mainly due to the variations in the volume of expenditure. The quantity theory, on the other hand, provides no clue to the business fluctuations.
7. Mysterious Behaviour of Money:
Income theory explains the mysterious behaviour of money that a shortage of money can generally stop the boom, but an abundance of money fails to initiate the recovery from a depression.
The primary factor which initiates recovery from depression is an increase in the investment expenditure rather than an increase in the money supply.
Investment expenditure is governed more by the marginal efficiency of capital (expected profitability) than the rate of interest. An increase in money supply may reduce rate of interest but it cannot improve the marginal efficiency of capital which is at a very low level during depression.
Thus, expansion in money supply generally proves ineffective in initiating recovery from depression. The quantity theory of money has no answer to this mysterious behaviour of money.