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INTRODUCTION
The definition and meaning of Quantity theory of money states that in an economy, the
money supply and price levels are in direct proportion to one another. When the money
supply changes, there is a proportional change in price levels, and when price levels
change, the money supply changes by the same proportion. The quantity theory of
money is the monetarist’s foundation, that claims that high inflation is caused by raising
the money supply at a faster rate than GDP (gross domestic product) growth. If the
money supply is controlled, the rest of the economy will look after itself, so say
monetarists.
Abstract
The quantity theory of money (QTM) refers to the proposition that changes in the quantity of
money lead to, other factors remaining constant, approximately equal changes in the price level.
Usually, the QTM is written as MV = PY, where M is the supply of money; V is the velocity of
the circulation of money, that is, the average number of transactions that a unit of money
performs within a specified interval of time; P is the price level; and Y is the final output. The
quantity theory is derived from an accounting identity according to which the total expenditures
in the economy (MV) are identical to total receipts from the sale of final goods and services
(PY). This identity is transformed into a behavioral relation once V and Y are assumed as given
or known variables. The QTM dates back to sixteenth-century Europe where it was developed as
a response to the influx of precious metals from the New World, and in this sense it is one of the
oldest theories in economics. Nevertheless, only in the writings of the late mercantilists does one
start to find theoretical statements that justify the connection between M and P. David Hume
(1711–1776) argued that assuming a case of equilibrium, an expansion in M (for example,
through the discovery of new gold mines) would make a group of entrepreneurs richer, and their
rising demand would increase the prices of products, thereby increasing the income of another
group of entrepreneurs whose demand would increase the price level even further, and so forth.
These chain effects at some point die out, and their end result would be the restoration of
equilibrium. Alternatively, if total output increases, the subsequent scarcity of money raises its
price above the normal level, and the excess profits in gold production lead to the expansion of
supply, thereby reducing the price of gold, which returns to its normal level, and equilibrium is
restored at a higher price level. Thus, the normal price of gold is what actually determines the
quantity of money in circulation.
Quantity theory of money equation
The quantity theory of money is built on an equation created by Irving Fisher (1867-
1947)
MxV=PxT
M = the stock of money. V = the velocity of circulation P = the average price level. T = all
the goods and services sold within an economy over a given time (some economist
may use the letter ‘Y’ for this value)
According to the equation – which is basically a truism – the amount of money spent
equals the amount of money used.
Supply of Money (MV)
The supply of money at any moment is the total quantity of money in existence at that
moment. Money includes not only coins and bank-notes but also bank deposits (only
current deposits on which cheques can be drawn should be counted). The quantity of
money, therefore, consists of the amount of money which people have (call it M) and the
number of times this money changes hands (the velocity of circulation of money, call it
V). The velocity of money comes in when we want to know the supply of money over a
period of time, say for instance, a year.
Money has wings, coins, banknotes, and bank deposits move round with great speed,
not staying in one person’s pocket or purse for more than a few days. Thus, the total
quantity, of money, at any moment, is denoted by Ml and over period of time by MV.
The Demand for Money (PT):
The demand for money arises from the fact that the goods and services have to be
exchanged for it. The demand for money is essentially the demand for transaction
purposes. Money is not demanded for its own sake but for the sake of things that if helps
to buy. The demand for money is equal to the total value of all goods and services
transacted. We estimate the total value of all goods and services by multiplying the total
amount of things (T) by the average price level (P). In Fisher’s equation the total value of
goods and services bought and sold (demand for money) is denoted by PT. So that, the
volume of money (MV) = total value of all goods and services (PT).
Thus, MV = PT or P = MV/T
where P is the price level, M the quantity of money, V the velocity of money and T the
total volume of goods and services transacted. Prof. Fisher further extended the
equation so as to include bank deposits (M’) and their velocity (V) in the total supply of
money. Thus,
P= MV + M’V’ /T
Assumptions of the Theory
The quantity theory of money is based on certain assumptions other things remaining
the same”. It assumes that V is constant and is not affected by the changes in the
quantity of money (M) or the price level (P). Velocity of money (V) depends upon
population, trade activities, habits of the people, interest rate, facilities for investment
etc. It is assumed that these factors have nothing to do with the changes in the value of
money. The quantity theorists ignored the velocity of money because they were
concerned with what Keynes calls transaction and precautionary motives for holding
money as long as we hold money for these purposes, the amount of money held may
remain stable but, as soon as we introduce the speculative motive for holding money, we
have to admit the possibility of a change in the velocity of money
The Classical Theory
The fundamental principle of the classical theory of money is that the economy is
self‐regulating. Classical economists maintain that the economy is always capable of
achieving the natural level of real GDP or output, which is the level of real GDP that is
obtained when the economy's resources are fully employed. While circumstances arise
from time to time that cause the economy to fall below or to exceed the natural level of
real GDP,self adjustment mechanism exist within the market system that work to bring
the economy back to the natural level of real GDP. The classical doctrine that the
economy is always at or near the natural level of real GDP is based on two firmly held
beliefs:says law and the belief that prices, wages, and interest rates are flexible.
According to says law, when an economy produces a certain level of real GDP, it also
generates the income needed to purchase that level of real GDP. In other words, the
economy is always capable of demanding all of the output that its workers and firms
choose to produce. Hence, the economy is always capable of achieving the natural
level of real GDP.
The achievement of the natural level of real GDP is not as simple as Say's Law would
seem to suggest. While it is true that the income obtained from producing a certain level
of real GDP must be sufficient to purchase that level of real GDP, there is no guarantee
that all of this income will be spent. Some of this income will be saved.Income that is
saved is not used to purchase consumption goods and services, implying that the
demand for these goods and services will be less than the supply. If aggregate demand
falls below aggregate supply due to aggregate saving, suppliers will cut back on their
production and reduce the number of resources that they employ. When employment of
the economy's resources falls below the full employment level, the equilibrium level of
real GDP also falls below its natural level. Consequently, the economy may not achieve
the natural level of real GDP if there is aggregate saving. The classical theorists'
response is that the funds from aggregate saving are eventually borrowed and turned
into investment expenditures, which are a component of real GDP. Hence, aggregate
saving need not lead to a reduction in real GDP.
Consider, however, what happens when the funds from aggregate saving exceed the
needs of all borrowers in the economy. In this situation, real GDP will fall below its
natural level because investment expenditures will be less than the level of
aggregate saving, represented by the curve S, is an upward‐sloping function of the
interest rate; as the interest rate rises, the economy tends to save more. Aggregate
investment, represented by the curve I, is a downward‐sloping function of the interest
rate; as the interest rate rises, the cost of borrowing increases and investment
expenditures decline. Initially, aggregate saving and investment are equivalent at the
interest rate, i. If aggregate saving were to increase, causing the S curve to shift to the
right to S′, then at the same interest rate i, a gap emerges between investment and
savings. Aggregate investment will be lower than aggregate saving, implying that
equilibrium real GDP will be below its natural level.
Flexible interest rates, wages, and prices. Classical economists believe that under
these circumstances, the interest rate will fall, causing investors to demand more of the
available savings. In fact, the interest rate will fall far enough—from i to i′ in Figure —to
make the supply of funds from aggregate saving equal to the demand for funds by all
investors. Hence, an increase in savings will lead to an increase in investment
expenditures through a reduction of the interest rate, and the economy will always
return to the natural level of real GDP. The flexibility of the interest rate as well as other
prices is the self‐adjusting mechanism of the classical theory that ensures that real GDP
is always at its natural level. The flexibility of the interest rate keeps the money market
or the market for loanable funds, in equilibrium all the time and thus prevents real
GDP from falling below its natural level.
Similarly, flexibility of the wage rate keeps the labor market, or the market for
workers, in equilibrium all the time. If the supply of workers exceeds firms' demand for
workers, then wages paid to workers will fall so as to ensure that the work force is fully
employed. Classical economists believe that any unemployment that occurs in the labor
market or in other resource markets should be considered voluntary unemployment
Voluntarily unemployed workers are unemployed because they refuse to accept lower
wages. If they would only accept lower wages, firms would be eager to employ
them.The immediate, short‐run effect is that the economy moves down along
the SAS curve labeled SAS 1, causing the equilibrium price level to fall from P 1 to P 2,
and equilibrium real GDP to fall below its natural level of Y 1 to Y 2. If real GDP falls
below its natural level, the economy's workers and resources are not being fully
employed. When there are unemployed resources, the classical theory predicts that the
wages paid to these resources will fall. With the fall in wages, suppliers will be able to
supply more goods at lower cost, causing the SAS curve to shift to the right
from SAS 1 to SAS 2. The end result is that the equilibrium price level falls to P 3, but the
economy returns to the natural level of real GDP.
ABSOLUTE INCOME HYPOTHESIS
Keynes’ Absolute Income Hypothesis
Abstract
The study investigates how consumption expenditure is determined by income according to
Keynes‟ Absolute Income Hypothesis (AIH) Estimating total household consumption
expenditure against total income. The AIH model was tested by ordinary least squares over the
period using data obtained from the World Bank national accounts data and Ivan Kushnir‟s
Research Center. We described and tested two important theoretical predictions of the
Keynesian AIH model; first, that the marginal propensity to consume (MPC) is constant and,
second, that the average propensity to consume (APC) declines as income increases. MPC
conform with Keynes earlier proposition that MPC is less than one, however it is not stable and
the value of the autonomous consumption is negative in the long run. We found also that the
APC did not vary systematically with income as conjectured by Keynes that it declines as income
increases. As a result, the income elasticity of consumption does not follow Keynes prediction.
Introduction
Consumption expenditure constitutes the largest proportion of the Gross Domestic Product in
most countries. In the words of Muellbauer and Lattimore (1994:292), „consumer expenditure
accounts for between 50% and 70% of spending in most economies. Not surprisingly, the
consumption function has been most studied of the aggregate expenditure relationships and
has been a key element of all the macroeconomic model building efforts since the seminal work
of Klein and Goldberger (1955).‟ It therefore becomes imperative to investigate how people
spend income in an economy in order to understand consumer behaviour.
Absolute Income Hypothesis
Consumption function is thought to have begun with Keynes‟s General Theory, though we need
not disregard excellent earlier work of Ramsey (1928) and Fischer (1930). Since then
consumption has been the subject of countless theoretical and empirical studies. Keynes
treated consumption on a very “common sense” level. He relied almost entirely on intuition -
like most other economists of his day, his methods included neither mathematical theory nor
detailed econometrics, as he demonstrated the central principle of his consumption theory.
According to Keynes an economic agent by natural instinct tend as a rule and on the average, to
increase his consumption as his income rises, but not by as much as the increase in his income.
In his work on the relationship between income and consumption, he came out with the finding
that income is the sole determinant of consumption (Tsenkwo, 2011). Keynes gave no basis for
his theory in terms of utility maximization nor indeed gave any consideration of why a
consumer would behave in the way he assumed. In place of rational-choice theory, Keynes
relied on his “knowledge of human nature.” Moreso, he did not give any support to his
postulate using numerical data, rather he claimed to glean support from “detailed facts of
experience.” While Keynes placed consumption theory at the center of the macroeconomic
stage. Based on Keynesian consumption function, the Absolute Income Hypothesis (AIH,
hereafter), aggregate consumption is a stable, but not necessarily linear, function of disposable
income,
Ct = α + βYt (1) where Ct and Yt denote the (real values of) total personal consumption
expenditure and total disposable income, respectively at time t. β, the marginal propensity to
consume (MPC) is expected to be constant and positive but less than unity, so that higher
income leads to higher consumption. The autonomous component of consumption, α, is
assumed to be small but positive. By capturing the conjectures of the fundamental law, the
absolute income hypothesis has these important features: (1) that the consumption
expenditure increases or decreases with increase or decrease in income but non-proportionally.
This non-proportional consumption function implies that in the short run average propensity to
consume (APC) is greater than the MPC: APC > MPC, where APC = and MPC this is because in
the short run autonomous consumption do not change with income but over the long period
horizon, as wealth and income increase, consumption also rises; the marginal propensity to
consume out of the long run income is closer to the average propensity to consume. (2) as
income rises, the proportion of it consumed falls: so the income elasticity of consumption
defined as would be less than unity. (3) that consumption function is stable both in the short
run and long run.
Life Cycle Hypothesis (LCH)
Modigliani and Brumberg‟s (1954 and 1980) life cycle hypothesis was designed to reconcile the
discrepancy between cross-sectional findings and the findings of time-series analysis. In
addition, the model was meant to capture the effect of liquid assets on consumption. Unlike
the Keynesian consumption theory that is entirely based on the current income of the
individuals, the concept of LCH assumes that all individuals consume a constant percentage
of present value of their life income. The life-cycle theory assumes that individuals or families
try to maximise the utility deriving from their entire life-cycle consumption. Therefore
consumption must be continuous, even if income through the life-cycle is discontinuous; and
saving is primarily done to finance consumption during the retirement period (see
Kankaanranta, 2006 ). According to Modigliani (1986 and 2001) the „basic‟ version of the life-
cycle hypothesis is based on the following assumptions: (1) Income is constant until retirement,
zero thereafter (2) Zero interest rate (3) Preferences: constant consumption over the life cycle
(4) Absence of bequests (Baranzini, 2005).
According to the life cycle hypothesis the average propensity to consume is larger in the old
households and among young people. This is because the old people run their lives on their life
savings while the young people are more into borrowing. The middle-aged people, on the other
hand, incline to have higher incomes with lower consumption and higher saving.
The Life Cycle Hypothesis can be explained by the equation
C = (W + RY) / T
Where W = Initial endowed wealth, R = Number of years earning labor income, Y = Labour
Income, and T = Number of years of the individual's lifespan.
Rewriting the equation or consumption function in equation C = W + Y
If every individual plans their consumption in such way, the aggregate consumption function of
the economy, will take the form C = W + δY (4) where parameter (= ) is the marginal
propensity to consume out of accumulated wealth and δ (= ) is the marginal propensity to
consume out of income.
The first result of this model is that the marginal propensity to consume (MPC) depends on
whether a change in income is expected to be temporary or permanent. First, consider a
temporary change in current income, which can be considered equivalent to a change in
current wealth, WR. Taking the derivative of average annual consumption, equation (4), with
respect to initial wealth, W, and we get the marginal propensity to consume out of a temporary
change in income. The marginal propensity to consume out of a temporary change in income
will always be equal to 1 divided by the number of years an economic agent expects to live.
Whereas, the marginal propensity to consume out of a change in labour income is always the
number of years of labor divided by the number of years the household expects to live.
Permanent Income Hypothesis (PIH)
In response to this empirical puzzle, Milton Friedman (1957) proposed his permanent income
hypothesis (PIH) which maintains that households spend a fixed fraction of their permanent
income on consumption. Unlike AIH, the PIH was inspired by micro-foundations and
representative agents, and highlighted the importance of not just the present but also future.
The core of Friedman‟s PIH was that individuals want to maximize their lifetime well-being
(utility) subject to the constraint that all their lifetime resources must be spent. The Friedman‟s
theory focused on distinguishing between consumption and current expenditure on the one
hand, and income and current receipts on the other hand. This is because an individual
economic agent is thought to plan his expenditures on both income received during the current
period and income expected during his lifetime. Therefore, consumers plan their expenditure
on the grounds of a long-run view of the resources that will accrue to them in their lifetime.
As a result, Friedman postulated that income, Y, is made up of two components: a permanent
component (YP) and transitory component (YT). Friedman argued that some of the factors that
give rise to the transitory component of income were specific to particular consumer but that
for any considerable group of consumers the transitory components tend to average out so
that the mean of the transitory component is expected to be zero. On the corollary,
consumption expenditures comprise permanent (CP) and transitory components (CT). The
permanent component relates to the amount that consumers plan to consume to maximize
their lifetime utility. Without uncertainty, total consumption would be equal to CP. CT relates to
all „other‟ factors. (Fernandez-Corugedo, 2004)
The PIH gives rise to a consumption function of the form: CP = k(r, w, u) x Yp (1) Y = YP + YT
(2) C = CP + CT (3) where C = current consumption spending, CP = permanent consumption,
CT = transitory consumption, Y = current income, YP = permanent income, YT = transitory
income, r = rate of interest at which the consumer can borrow or lend, w = ratio of wealth to
income and u = consumer‟s taste preferences. Equation (1) defines the relationship between
permanent consumption and permanent income, and the marginal propensity to consume out
of permanent income, k(·) is independent of the size of permanent income but it does depend
on other variables: r, w and u. The equations (2) and (3) provide a means of linking actual
measured variables (C, Y) to their relevant components.
Under permanent income theory, the MPC is constant and equal to the APC, which is consistent
with Kuznets‟ (1946) empirical findings. The MPC is also the same for all households. Friedman
reconciled the difference between cross-section regression estimates of consumption and long
run aggregate time series regression estimates by appeal to a statistical “errors-in-variables”
argument. The argument is that cross section estimates use actual household income rather
than permanent household income. Owing to the fact that more households are situated in the
middle of the income distribution, the observed distribution of actual household income tends
to be more spread out than permanent income. Consequently, regression estimates using
actual income tend to find a flatter slope, and hence the finding that cross section consumption
function estimates are flatter than time series aggregate per capita consumption function
estimates. Friedman‟s PIH therefore offered a simple explanation of the empirical consumption
puzzle. At the theoretical level, the innovation was the construct of permanent income that
introduced income expectations, thereby adding a sensible forward-looking dimension to
consumption theory (Palley, 2008). The Friedman‟s theory had important implications for fiscal
policy. First, since all households have the same MPC it undermined the Keynesian demand
stimulus argument for progressive taxation.
Second, it introduces a distinction between permanent and temporary tax shocks. For policy
makers, the source and nature of the shocks are important. For instance, an announcement
that tax cuts will be permanent would lead to different behavior of household/firm economic
agent compared to when such tax changes are thought to only be transitory.
α = Autonomous Consumption (independent of the level of income)
β =Marginal Propensity to Consume (MPC), 0 < β < 1
YGNI = Total Disposable Income in year t
In the analysis of the common components of household consumption expenditure and GNI per
capita, standard time series unit root tests can be applied. To ensure robustness we use several
unit root tests, including the Augmented Dickey and Fuller (1979) (ADF) test, the Phillips and
Perron(1988) (PP) test, as well as the Kwiatkowski, Phillips, Schmidt, and Shin (1992) (KPPS)
test. The latter tests the null of stationarity whereas the former two investigate the null of a
unit root. We do not further discuss the details of these well-known time series unit root tests
but instead call attention to Maddala and Kim (1998) for their excellent treatment of ADF, PP
and KPSS. Nelson and Plosser (1982) indicate that many macroeconomic time series data have a
stochastic trend plus a stationary component, that is, they are difference stationary processes.
It is also of great importance to discern the temporary and permanent movements in an
economic time series. Economic theory in this line assumes that at least some subsets of
economic variables do not drift through time independently of each other and some
combination of the variables in these subsets reverts to the mean of a stable stochastic process.
Granger (1986) and Engle and Granger (1987) indicate that even though economic time series
may be non-stationary in their level forms, there may exist some linear combination of these
variables that converge to a long run relationship over time, which also requires the existence
of Granger causality in at least one direction in an economic sense as one variable can help
forecast the others.
A lot of techniques are available to test for the existence of long-run equilibrium relationships
in the levels among variables. Two popular cointegration tests, namely, the Engle-Granger (EG)
test and the Johansen test are used. The EG test is contained in Engle
8
and Granger (1987) while the Johansen test is found in Johansen (1988) and Johansen and
Juselius (1990). The EG test involves testing for stationarity of the residuals. If the residual
series is stationary, the variables CHTCE and YGNI are cointegrated and if it is non-stationary,
the variables are not cointegrated. The EG approach could exhibit some degree of bias arising
from the stationarity test of the residuals from the chosen equation. The EG test assumes one
cointegrating vector in systems with more than two variables and it assumes arbitrary
normalization of the cointegrating vector. Nevertheless we adopted EG test because the
variables of interest in this study are two, CHTCE and YGNI. Figure 1 shows the trend of
household income and consumption.
SUMMARY AND CONCLUSION
The purpose of the study was to test the Keynesian AIH and analysis Kuznets Puzzle for Nigeria.
We have described and tested two important theoretical predictions of the Keynesian AIH
model; first, the marginal propensity to consume is constant and, second, the average
propensity to consume declines as income increases. Using Nigeria economic data, we
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