Question

 "In an economy, the total value of all goods sold during any period must be equal to the total quantity of money spent during that period". This statement reflects which approach of 'Quantity Theory of Money'?
1. Cash balance approach
2. Transaction approach
3. Cambridge approach
4. Income-Expenditure Approach

Answer 1

Correct Answer - Option 2 : Transaction approach

The correct answer is Transaction approach.

• The Quantity Theory of Money
  • It seeks to explain the factors that determine the general price level in a country.
  • The theory states that the price level is directly determined by the supply of money.
• Transaction Approach :
  • The transactions version of the quantity theory of money was provided by the American economist Irving Fisher in his book- The Purchasing Power of Money (1911).
  • According to Fisher, Keeping other factors at constant, an increase or decrease in the price level would occur due to an increase or decrease in the quantity of money.
  • This approach may be explained with the following equation of exchange, MV = PT, where,

    • T = the total transactions in physical goods

    • P = the general price level

    • V = the velocity of circulation of money

    • M = the total supply of money

• According to the Transaction approach, If we consider the total transactions in physical goods (T) are constant then the velocity of circulation of money (V) could also remain constant. which suggests the total supply of money (M) is directly proportional to the general price level (P).

• Following assumptions can be drawn on the basis of Fisher’s transaction approach :

  • An increase in the total supply of money will increase the general price level.

  • This increase in the total supply of money decreases the value of money.

  • In an Economy Total expenditure (MV) means total sell (PT).

• Fisher’s Transaction Approach can explain the causes of hyperinflation that occurs during war or emergency. It can also explain certain long term trend in prices. But it cannot explain normal peacetime inflation. This shortcoming has been modified by the Cambridge version or the Cash-Balance Approach.

• Cash Balance approach or Cambridge version : 
  • The cash balances approach is the modification of the transaction approach and is widely accepted in Europe.
  • According to Alfred Marshall, the value of money depends on the demand and supply of cash balances for a given period of time. 
  • This approach is based on the national income approach and considers the concept of liquidity.
  • The demand for money is not only dependent on the quantity of goods and services that would be exchanged, but also on the time period at which the transaction takes place.
  • According to the cash balance approach, the public likes to hold a proportion of nominal income in the form of money (i.e., cash balances).