Income theory of money is the modern explanation of money and prices which has been developed as a protest against the traditional quantity theory of money.
The quantity theorists, by assuming full employment believed a direct and proportional relationship between the quantity of money and the price level; a change in money supply affects only the price level without altering the aggregate output.
Income theory of money, on the other hand, emphasizes that changes in the money supply can influence the price level only indirectly by causing changes in the volume of total expenditure and, consequently, in total output.
In this way, the income theory of money seeks to integrate the monetary theory and the general theory of income, output and employment and thus to end the classical dichotomy between the two.
According to the income theory of money, it is the money income and the volume of expenditure, and not the supply of money (as in the quantity theory of money), which is a strategic factor influencing the prices as well as the output level:
(a) An increase in the total money income (in the form of rent, wages, interest and profits received by the factors of production) by increasing the total expenditure increases total output and employment,
(b) Increased total expenditure increases prices to the extent to which the production is inelastic due to certain bottlenecks in the production process,
(c) After the level of full-employment is achieved, the increased total expenditure leads to a proportionate increase in prices without affecting total output.