Question

Explain the Fisher Quantity Theory of Money

Answer 1

Fisher’s quantity theory is best explained with the help of his famous equation of exchange

MV = PT or P = MV/T

Like other commodities, the value of money or the price level is also determined by the demand and supply of money.

i. Supply of Money:

The supply of money consists of the quantity of money in existence (M) multiplied by the number of times this money changes hands, i.e., the velocity of money (V). In Fisher’s equation, V is the transactions velocity of money which means the average number of times a unit of money turns over or changes hands to effectuate transactions during a period of time.

Thus, MV refers to the total volume of money in circulation during a period of time. Since money is only to be used for transaction purposes, total supply of money also forms the total value of money expenditures in all transactions in the economy during a period of time.

ii. Demand for Money:

Money is demanded not for its own sake (i.e., for hoarding it), but for transaction purposes. The demand for money is equal to the total market value of all goods and services transacted. It is obtained by multiplying total amount of things (T) by average price level (P).

Thus, Fisher’s equation of exchange represents equality between the supply of money or the total value of money expenditures in all transactions and the demand for money or the total value of all items transacted.

Supply of money = Demand for Money

Or

Total value of money expenditures in all transactions = Total value of all items transacted

MV = PT

or

P = MV/T

Where,

M is the quantity of money

V is the transaction velocity

P is the price level.

T is the total goods and services transacted.

The equation of exchange is an identity equation, i.e., MV is identically equal to PT (or MV = PT). It means that in the ex-post or factual sense, the equation must always be true. The equation states the fact that the actual total value of all money expenditures (MV) always equals the actual total value of all items sold (PT).

What is spent for purchases (MV) and what is received for sale (PT) are always equal; what someone spends must be received by someone. In this sense, the equation of exchange is not a theory but rather a truism.

Fisher was able to demonstrate a causal relationship between money supply and price level.

In this way, Fisher concludes, “… the level of price varies directly with the quantity of money in circulation provided the velocity of circulation of that money and the volume of trade which it is obliged to perform are not changed”. Thus, the classical quantity theory of money states that V and T being unchanged, changes in money cause direct and proportional changes in the price level.

Irving Fisher further extended the equation of exchange so as to include demand (bank) deposits (M’) and their velocity, (V’) in the total supply of money.

Thus, the equation of exchange becomes:

MV + M'V'   = PT

  P =   ( MV + M'V' ) / T

Thus, according to Fisher, the level of general prices (P) depends exclusively on five definite factors:

(a) The volume of money in circulation (M);

(b) Its velocity of circulation (V) ;

(c) The volume of bank deposits (M’);

(d) Its velocity of circulation (V’); and

(e) The volume of trade (T).

Assumptions of Fisher’s Quantity Theory:

Fisher’s transactions approach to the quantity theory of money is based on the following assumptions:

1. Constant Velocity of Money: According to Fisher, the velocity of money (V) is constant and is not influenced by the changes in the quantity of money. The velocity of money depends upon exogenous factors like population, trade activities, habits of the people, interest rate, etc.

2. Constant Volume of Trade or Transactions: Total volume of trade or transactions (T) is also assumed to be constant and is not affected by changes in the quantity of money. T is viewed as independently determined by factors like natural resources, technological development, population, etc., which are outside the equation and change slowly over time. Thus, any change in the supply of money (M) will have no effect on T.

3. Price Level is a Passive Factor: According to Fisher the price level (P) is a passive factor which means that the price level is affected by other factors of equation, but it does not affect them. P is the effect and not the cause in Fisher’s equation. An increase in M and V will raise the price level. Similarly, an increase in T will reduce the price level.

4. Money is a Medium of Exchange: The quantity theory of money assumed money only as a medium of exchange. Money facilitates the transactions. It is not hoarded or held for speculative purposes.

5. Constant Relation between M and M’: Fisher assumes a proportional relationship between currency money (M) and bank money (M’). Bank money depends upon the credit creation by the commercial banks which, in turn, are a function of the currency money (M). Thus, the ratio of M’ to M remains constant.

6. Long Period: The theory is based on the assumption of long period. Over a long period of time, V and T are considered constant.

Broad Conclusions of Fisher’s Quantity Theory:

(i) The general price level in a country is determined by the supply of and the demand for money.

(ii) Given the demand for money, changes in money supply lead to proportional changes in the price level.

(iii) Since money is only a medium of exchange, changes in the money supply change absolute (nominal), and not relative (real), prices and thus leave the real variables such as employment and output unaltered. Money is neutral.

(iv) Under the equilibrium conditions of full employment, the role of monetary (or fiscal) policy is limited.

(v) During the temporary disequilibrium period of adjustment, an appropriate monetary policy can stabilise the economy.

(vi) The monetary authorities, by changing the supply of money, can influence and control the price level and the level of economic activity of the country.