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The Quantity Theory of Money: Understanding its Impact on Prices and Inflation in Economic Contexts

  • 05 Pages
  • Published On: 05-12-2023

What assumptions need to hold true for the Quantity Theory of Money to hold true and why might these assumptions not hold true?

The quantity theory of money is a common theory often applied within the field of monetary economy and it generally premises that the average prices of goods and services within an economy fluctuate on account of the total money supply within the same economy or market (Friedman, 2010). According to Barone (2020), the theory stipulates that should money in an economy double up in supply so will the price levels of multiple products and services ultimately impacting an increase in inflation levels. The theory is often presented by the equation M x V = P x T, where M is money supply, V is Velocity of Money or the rate at which people spend money. P is the average price level while T is the volume of transactions (Sargent, and Surico, 2011)

The major assumption of the theory is that the rate at which people spend money (V) is constant and the volume or number of transactions (T) is also stable. The theory assumes that these two factors are neither affected by the money supply nor the price levels of products and services (Hillinger, and Süssmuth, 2010). However, these assumptions might not be true because in the actual economic setting all the four factors interact with each other and are effectively affected by any fluctuations in anyone of them. Agarwal (2020) advances that the Velocity of Money (V) is inherently dependent on multiple factors including the demographics of an economy, individual customer habits, available trading activities, opportunities for investment and many others, all of which are directly impacted by money supply. In addition the concept of saving or speculative holding of money by customers significantly impacts both money supply and Velocity of money.

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Further while the theory assumes that the volumes of products (T) and services remain constant across the economy this is in fact not entirely true given significant factors that impact production and that vary every year. Agarwal (2020) confirms that T is impacted by factors such as availability of resources, Climatic conditions, labor productivity, production technique, transport availability and many others. As such more often than not these factors fluctuate leading to a fluctuation of the total amount of products and services produced thereby potentially nullifying the theory. The theory also assumes that the price levels P and the money supply levels M, are passive factors which are impacted by the velocity of money and volume of transactions but do not impact them back. However in the actual economy all the four factors interact and impact each other proportionately.

Explain why nationalism might lead to a ‘fallacy of composition’ for interdependent nations.

Nationalism is an idea or movement that aims to promote the interest of a collective group of people specifically with the aim of gaining and maintaining national sovereignty (Greenfeld, 2012). It is a concept that was developed in the 18th century and presents that individuals unified by common native land and traditions should also share territorial authorities and protect themselves against others who are not part of the group or Nation. Kohn (2021) advances that the ideology of Nationalism is based on the premise that a citizens’ loyalty and devotion to their nation/state surpasses any other interest from other groups or individuals. Nationalism brings individuals within a group together in common goal of love and support to one another as well as protection from common allies (Cline, 2010). It can be a significant common unifying factor especially when the priorities of the state/nation are significant and effective for all the individuals within a Nation. However it can also lead to a fallacy of composition for interdependent states.

According to Gough and Daniel (2020) a fallacy of composition arises from arguments stating that something must be true for the whole group if it is true for some part of the group. It entails treating a non common characteristic of a group as if it was a collective by attributing to an entire group different characteristic that is only true for some of the individuals’ members of a group. Interdependent nations often have symbiotic agreements for mutual exchanges of resources for instance trading products or services and sometimes even information and knowledge. As a result, different individuals within different nations will perceive and judge a nation based on its governments’ decisions and activities as a representative of the whole country. Overtime the fallacy of composition arises as a result of Nationalism when different countries and individuals stereotype a nation based on the attitudes, character and activities of its government or a single group of people. For instance, if one or two members of a nation’s (X) government are charged with a corruption scandal, a fallacy of composition arises when other nations and individuals automatically conclude that people from nation X are corrupt.

What is the ‘Keynesian Multiplier’ and what things might decrease its magnitude?

A Keynesian Multiplier according to CFI (2020), refers to an economic theory premising that an increase in both private and government spending over a period of time ultimately leads to an increase in the GDP by more than the amount of the increase. The basic principle behind the theory is that the more the government invests or spends in an economy the better chances the economy has to ultimately flourish. Government spending not only supports private spending and investment but also provides a significant boost to the private economy investment leading to a higher overall outcome (Cogan et al., 20110). As such, if the private expenditure increases by N units the total eventual GDP will increase by more than N units. Similarly if the governments’ expenditure increases by Y units then the eventual overall GDP will also increase by more than Y units. The general idea is that regardless of the investment or type of expenditure made, the increase triggers a cycle of economic prosperity which impacts factors such as increased employment and production leading to the ultimate rise of the GDP by a much higher figure than invested.

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An initial decrease in investment made by the government or private sector as well as potential leakages often lead to a potential decrease in the multipliers magnitude thereby leading to a greater decrease of the ultimate GDP. A decrease in investment automatically decreases the level of production and may significantly impact employment leading to minimized production. Also according to Mukherjee (2020) leakages such as savings and paying off of debts by private organizations may also significantly impact a decrease in the multiplier.

Often businessmen and companies take loans to manage and enhance their businesses from various financial institutions, when part of their income is used to pay these loans (and the lenders save the money) the money leaves the income stream and as such significantly leads to a decrease in the multipliers magnitude. However if the lenders loan the money back to others then it rejoins the income stream and eventually impact GDP. The multiplier’s magnitude is also effectively decrees by other leakages such as individual holding of idle cash balances as a result of increased incomes, increased taxation rates and possible inflation in the price of products and services. All these leakages serve to take money out of the general income stream and therefore impact the ultimate GDP.

References

Agarwal, M., 2020. Quantity Theory of Money and its Assumptions – Explained !. [online] Economics Discussion. Available at: [Accessed 17 March 2021].

Barone, A., 2020. What Is the Quantity Theory of Money?. [online] Investopedia. Available at: [Accessed 17 March 2021].

CFI, 2020. Keynesian Multiplier - Overview, Components, How to Calculate. [online] Corporate Finance Institute. Available at: [Accessed 17 March 2021].

Cline, W.R., 2010. Exports of manufactures and economic growth: The fallacy of composition revisited. Globalization and Growth, 195.

Cogan, J.F., Cwik, T., Taylor, J.B. and Wieland, V., 2010. New Keynesian versus old Keynesian government spending multipliers. Journal of Economic dynamics and control, 34(3), pp.281-295.

Friedman, M., 2010. Quantity theory of money. In Monetary economics (pp. 299-338). Palgrave Macmillan, London.

Gough, J. and Daniel, M., 2020. What Is The Fallacy of Composition? Definition And Examples - Fallacy In Logic. [online] Fallacy In Logic. Available at: [Accessed 17 March 2021].

Greenfeld, L., 2012. Nationalism. The Wiley‐Blackwell Encyclopedia of Globalization.

Hillinger, C. and Süssmuth, B., 2010. The Quantity Theory of Money: An Inquiry Regarding Meaning and Method. Available at SSRN 1543727.

Kohn, H., 2021. nationalism | Definition, History, & Facts. [online] Encyclopedia Britannica. Available at: [Accessed 17 March 2021].

Mukherjee, S., 2020. Keynes' Theory of Investment Multiplier (With Diagram). [online] Economics Discussion. Available at: [Accessed 17 March 2021].

Sargent, T.J. and Surico, P., 2011. Two illustrations of the quantity theory of money: Breakdowns and revivals. American Economic Review, 101(1), pp.109-28.

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