The Quantity Theory of money was first developed by Irving Fisher in the inter-war years to explain the theoretical explanation for the link between money and the general price level. This is sometimes known as the Fisher identity or the equation of exchange. This is an identity which relates total aggregate demand to the total value of output (GDP).
MV = PY
M is the money supply
V is the velocity of circulation of money i.e. the no. of times a unit of currency changes hands
P is the general price level
Y is the real value of national output (i.e. real GDP)
- Velocity of money is treated to be constant as it is predictable.
- It is assumed that real value of GDP is not affected by monetary variables.
Hence, assuming V and Y to be constant, changes in supply of money will be equated by changes in general price level.
We can further modify this relationship by dividing both sides by V:
M = (1/V) x PY
Since V is constant we can replace (1/V) with some constant, k, and when the money market is in equilibrium, Md = M. So our equation becomes
Md = k x PY
So under the quantity theory of money, money demand is a function of income and does not depend on interest rates.
Money supply means total amount of money available in an economy. In other words, money supply refers to the volume of money held by the people in the country for transactions or for settlement of debts.
Money supply is actually money stock. Supply of money does not include:
- Stock of the money held by the government
- Stock of money held by banking system (Commercial ¢ral bank)
Government & banks are suppliers of money or producers of money. Hence money held by them is not a part of stock of money held by the people.
Supply of money refers to the stock of money held by the public or those who demand money.
Components of Money supply:
- Currency component
- Deposit component (Commercial and central bank)
Measures of Money supply:
In India, RBI has used four measures of money supply since 1977. These measures are M1, M2, M3 and M4. These measures are shown as under:
M1=Currency with the public +Demand deposits of Banks + Other deposits with RBI
M2=Currency with the public + Demand deposits of Banks + Other deposits with RBI+ Saving Deposits in Post Offices
M2=C+DD+OD+SD or M2=M1+SD
M3=Currency with the public + Demand deposits of Banks + Other Deposits with RBI +Time Deposits in Banks
M3= C+DD+OD+TD or M3=M1+TD
M4= Currency with the public + Demand deposits of Banks + Other Deposits with RBI +Time Deposits in Banks+ Saving Deposits in Post Offices
M4=C+DD+OD+SD or M2=M1+SD