Classical and Neo-Classical Version of Quantity Theory

Read this article to learn about the choice between classical and neo-classical version of quantity theory.

In the bottleneck inflationary situations so prominently characteristics of developing economies like India the orthodox quantity theory has perhaps greater use as a tool of economic analysis, for the conditions underlying the quantity theory seem to obtain largely in these economies.

In-so-far as currency constitutes by far the most important part of total money supply and money is held primarily for transactions rather than for speculative purposes—an almost direct link can be traced between money supply on the one hand and the price level on the other.

The composition of ‘reserve money’ as well as the low Money-Multiplier ratio in India indicate that preference for cash transactions has not undergone any substantial change over the past twenty years.

The quantum of money supply is largely dependent on the currency liabilities of the central bank and with a not very high ratio of multiple credit creation, the central bank can vary the quantum of money supply considerably only by varying its currency liabilities.

Further it would not be wrong to assume that in view of the inelasticity of real output, a developing economy usually exhibit the characteristics of a ‘full employment economy’ in which the quantity theory comes into its own. Moreover, the data relating to fundamental variables involved in Keynesian income-expenditure or subsequent approaches are far too inadequate and undesirable in such economies to be used as the basis for any generalizations.

There are, however, others who point out that the classical-neo-classical version of the quantity theory does not find support from Indian data. It is, therefore, clear that the developing countries must gear up their monetary policies keeping in view these vital and empirical facts. The growth of money supply in the context of development derives its importance from the inflationary impact that it may have on prices. Given the rate of growth of national product, there is an appropriate relationship between the growth of output and the growth of money supply.

In fact, there may be several reasons for which an expanding money supply may be necessary in a developing economy, for example, increases in national real output will require corresponding increases in money supply for transactions purposes; economic development leads to the expansion of monetized sector, which necessitates further increase in the demand for money; again, as money incomes rise, the money/income ratio (M/Y), the Marshallian ‘R’ also tends to rise. Thus, we find that in developing economies also, money supply changes are not passive factors. At the same time the ‘veil’ of money approach need not hold back development provided the allocation of physical resources is designed to achieve steady growth.