Income Theory of Money and Prices: Income-Expenditure Approach

Read this article to learn about the income-expenditure approach of income theory of money and prices.

We know that both MV = PT and M = PKT approaches are helpful as long as we are concerned with the value of money, but the moment we move on to the determination of the total income, output and employment, the income-expenditure equation Y = C + I becomes a more useful tool of analysis.

Whatever be the relative merits and demerits of the transactions and cash-balances versions of the quantity theory of money, the fact remains that lot of time and energy was wasted as both the versions failed to establish the true and real causal relationship which exists between money and prices, till the new approach of saving and investment, also called the income-expenditure approach to the value of money, was evolved.

According to this approach value of money (price level) is more a matter of total income than the quantity of money. The value of money, in fact, is a consequence of the total income rather than of the quantity of money. It stresses the fact that quantity of money is more often a result than a cause of the level of incomes. The version brings forth the fact that value of money is affected not by its quantity but by the total income. If income increases, spending will also increase and prices will go up, the value of money will fall.

The essence of income theory of prices is that Y and E of a community are the key determinants of the relationship between M and P. According to this approach, it is’ the volume of expenditures, not the quantity of money, to which primary attention must be given and the factors affecting aggregate outlays (income) are more complex than those conventionally considered by quantity theory of money.

The quantity theory had been found inadequate as it was concerned with prices and not with income. Total expenditures or total money income had no importance in terms of employment, output or real income. According to the quantity theory, it is the quantity of money (M) and its velocity (V) which explains the level of income. According to the income theory, it is the flow of expenditures which explains the quantity of money and its velocity.

The income theory does not deny an important role of the money supply—money is an important variable but its impact on prices cannot be taken for granted. The problem is: What part does money play in income determination?

Tooke on the Income Theory:

The income-expenditure approach to the quantity theory of money was not unknown before Keynes. In 1844, Tooke showed that it was income rather than the quantity of money that determined prices. He stated, “The prices of commodities do not depend upon the quantity of money…on the contrary, the amount of circulating medium is a consequence of prices.”

Prof. Wicksell and Prof. Aftalion developed their theories of money and prices based on these ideas. Other advocates of this theory are Schumpeter, Hawtrey and Robertson. Tooke argued that it was income that determined prices. In other words, according to Tooke, the level of prices is determined by the relation of aggregate demand to aggregate supply. Symbolically, it means that P_e = D_e/O_e in which P_e is the price level of consumption goods, D_e is the aggregate demand for consumer goods and O_e is the aggregate supply of consumer goods.