What is the Income Theory of Money?

The development of income-expenditure approach, or simply, the income theory of money as an explanation of the inter-relationships of money, prices and economic activity, has been a landmark in the history of monetary thoughts since World War I and especially since the onset of the Great Depression on 1929.

Wicksell, Afflation, Schumpeter, Hawtrey, Robertson, Keynes are the outstanding contributors to this celebrated approach in monetary analysis.

The income theory of money (called ITM, hereafter) has been the outcome of the disagreement of these economists with the quantity theorists. The quantity theorists furnished a weak explanation of the changes in prices and the value of money.

They asserted that a change in the aggregate demand for goods and services is caused by a change in the supply of money, and that an increase in money supply would create an increased demand for goods of all kinds and vice versa.

But empirical studies have shown that there is no essential relationship between the demand for goods and the money supply. For example, a depression is the result of a decrease in the aggregate demand, which sets in without any appreciable contraction in money supply.

The income theorists, on the other hand, rightly conceived that changes in demand are a result of changes in income rather than of the money supply. The aggregate demand for goods and services is determined by the size of the money income of the community.

A rise in money income places, a larger amount of purchasing power in the hands of people, thereby increasing their demand for goods and services. If the elasticity of production is high, an increase in aggregate demand would raise the level of production and employment without having much effect on prices.

But, when production is not sufficiently elastic or where productive resources are fully employed, or where there are “bottlenecks” preventing output from increasing in proportion to the increased demand, the rise in money income would cause prices to rise.

The levels of price, production and employment are, therefore, determined by the size of money income in relation to real income.

Thus fluctuations in the aggregate income, and not the money supply as such, are the main determinants of aggregate demand, and these, in relation to the aggregate supply of goods and services, are responsible for changes in prices and economic activity.

In fact, money supply itself may change due to variations in the level of income, prices and economic activity, but not the other way round. Hence, the kernel of the income theory is that: The value of money, in fact, is “a consequence of the total income rather than the quantity of money.”

There are two inter-related approaches to the ITM, namely: (i) the Income-Expenditure approach; and (ii) the saving and Investment approach.