Question

The primary criticism Keynes leveled against Fisher’s theory of money demand is the prediction that the velocity of money is constant. Keynes stated that the data on velocity showed unambiguously that velocity fluctuated significantly in the short run. Explain how Keynes’ theory of money demand allows for such short-run fluctuations.

Answer 1

In his theory of demand for money, Irving Fisher emphasized on the functions of money under medium of exchange, which refer money as a means of purchasing goods and services.

MV = PT

where :

M = quantity of money in circulation

V = velocity of transactions in circulation

P = avg. price

T = total transactions made

According to him, the Central Bank of any country fixes the nominal quantity of money (M). Which is hence, referred to as an exogenous variable having a particular quantity of money in a given period of time.

Further, he stated that the total GDP or national income of a nation depends on the amount of fully employed resources present in an economy making the transactions(T) fixed in the short-run.

Though circulation of velocity (V),remains to be constant and independent of the other factors - M,P & T. While, the institutional and technological factors do not change in the short-run.

On the other hand Keynes, profounded the theory for demand of money to hold, also called as liquidity preference theory in the short-run. He treated money in terms of store of value, as an individual's wealth.

According to Keynesian theory of money demand, the velocity of circulation(V) of money depends on the interest rates, taxes, and other government expenditures in the short-run too.

Therefore, he stated and criticized Fisher's theory by saying that velocity of money in circulation can't be constant in the short-run as changes in the level of interest-rates, taxes imposed and various expenditures made by the government.