THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 585

CHAPTER 21

The Demand for Money

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Irving Fisher reasoned that velocity is determined by the institutions in an
economy that affect the way individuals conduct transactions. If people use
charge accounts and credit cards to conduct their transactions, as they can
today, and consequently use money less often when making purchases, less
money is required to conduct the transactions generated by nominal income (M
falls relative to P * Y ), and velocity (P * Y )/M will increase. Conversely, if it
is more convenient for purchases to be paid for with cash or cheques (both of
which are money), more money is used to conduct the transactions generated
by the same level of nominal income, and velocity will fall. Fisher took the view
that the institutional and technological features of the economy would affect
velocity only slowly over time, so velocity would normally be reasonably constant in the short run.

Quantity
Theory of
Money

Fisher s view that velocity is fairly constant in the short run transforms the equation of exchange into the quantity theory of money, which states that nominal
income is determined solely by movements in the quantity of money. When the
quantity of money M doubles, M * V doubles and so must P * Y, the value of
nominal income. To see how this works, let s assume that velocity is 5, nominal
income (GDP) is initially $5 trillion, and the money supply is $1 trillion. If the
money supply doubles to $2 trillion, the quantity theory of money tells us that
nominal income will double to $10 trillion (+ 5 * $2 trillion).
Because the classical economists (including Fisher) thought that wages and
prices were completely flexible, they believed that the level of aggregate output Y

produced in the economy during normal times would remain at the full-employment
level, so Y in the equation of exchange could also be treated as reasonably constant
in the short run. The quantity theory of money then implies that if M doubles, P
must also double in the short run because V and Y are constant. In our example, if
aggregate output is $5 trillion, the velocity of 5 and a money supply of $1 trillion
indicate that the price level equals 1 because 1 times $5 trillion equals the nominal
income of $5 trillion. When the money supply doubles to $2 trillion, the price level
must also double to 2 because 2 times $5 trillion equals the nominal income of
$10 trillion.
For the classical economists, the quantity theory of money provided an explanation of movements in the price level. Movements in the price level result
solely from changes in the quantity of money.

Quantity
Theory of
Money
Demand

Because the quantity theory of money tells us how much money is held for a
given amount of aggregate income, it is in fact a theory of the demand for money.
We can see this by dividing both sides of the equation of exchange by V, thus
rewriting it as
M =

1
* PY
V

where nominal income P * Y is written as PY. When the money market is in
equilibrium, the quantity of money M that people hold equals the quantity of
money demanded Md, so we can replace M in the equation with Md. Using k to

represent the quantity 1/V (a constant because V is a constant), we can rewrite
the equation as
M d = k * PY

(3)