Quantity Theory of Money, Fisher’s Equation

Quantity Theory of Money and Fisher’s Equation. This blog post delves into the Quantity Theory of Money, a fundamental concept in macroeconomics that explores the relationship between the money supply, price levels, and economic output. It also examines Fisher’s Equation of Exchange, a mathematical representation that quantifies this theory. Perfect for economics, business, and finance students, this post provides clear explanations, real-world examples, and insights into the implications of monetary policy and inflation in today’s economy. This topic is equally important for the students of economics across all the major Boards and Universities such as FBISE, BISERWP, BISELHR, MU, DU, PU, NCERT, CBSE & others & across all the business & finance disciplines.

Quantity Theory of Money, Fisher’s Equation

Quantity Theory of  Money

Quantity Theory of Money explains that the quantity of money in an economy has link with the price level. Generally, we can say that price level of goods and services has proportional relation with supply of money which means it supply of money doubles, the price level of goods and services also doubles. Rising price level also causes inflation. Theory was originally given by Polish Mathematician Nicolaus Copernicus in 1957 but later it was popularized by economist Milton Friedman in 1963.

John Stuart Mill’s Definition

“The value of money, other things being the same, varies inversely as its quantity; every increase of quantity lowering its value, and every diminution raising it in the same proportion.”

F.W. Taussig’s Definition

“Other things being equal, prices rise and fall in direct proportion to the quantity of money in circulation.”

Irving Fisher’s Equation

American Economist Irving Fisher presented the equation of exchange and described the relationship between the quantity of money and the value of money as given below:

where:

P = Average Price Level

M = Quantity of Legal Money

V = Velocity of Money in circulation

M’ = Quantity of Credit Money

V’ = Velocity of Credit Money in circulation

T = Total transaction

Explanation

For explanation, we are taking one example in which we assume that T, V, V’ are constant and the ratio between legal money and credit money also remain the same.

Case 1

M = 4000, M’=8000, V = 4, V’ = 4 and T = 4000

Case 2

Now doubles the quantity supply of money:

M = 8000, M’=16000, V = 4, V’ = 4 and T = 4000

Case 3

Now one half the quantity supply of money:

M = 2000, M’=4000, V = 4, V’ = 4 and T = 4000

Assumptions

Constant Velocity of Money (V)

The circulation speed of the money in the economy remains same.

Full Employment

It is also assumed that there is full employment in the economy in result transaction level T remains the same.

Constant Hoardings

It is assumed that there is no change in hoardings because if people save most of money and convert it to hoardings, the quantity of money will fall.

Eliminate Barter System

There is no barter system in the country. In presence of barter system there is no circulation of money.

Closed Economy

The theory assumes no external trade influences or leakages.

Criticism

Neglect of Output Variability

It is assumed that output T remains constant but it is not possible, it changes due to several other reasons.

Changing Velocity of Money

Velocity (V) is not constant and varies with technological advancements, financial innovations, and economic cycles.

Oversimplified Assumptions

The theory assumes a direct relationship between money supply and price level, ignoring factors like demand, fiscal policies, and external influences.

Empirical evidence

Historical data shows periods where inflation and money supply did not move proportionally, challenging the theory’s universal applicability.

Price change for all goods is not same

It is assumed that prices changes at the same time for all goods but in reality it is not for all. Price changes for some goods and some goods do not react regarding price with time delay.

Demand side of Money is Ignored

Factors influence demand for money also influence price level which is ignored in the theory.

Constant Out

It is assumed in the theory that there is constant output in the economy but in reality it is not possible. Output of goods and services has variation.

Full Employment

It is also assumed that there is full employment in the economy but in reality it is impossible to achieve full employment and then sustain it.

Better Use of Resources

If we use inefficient resources in the economy to increase the production of goods and services and increase the money supply then price level will remain the same or even falls due to excessive output of goods and services.

Relation with Interest

Supply of money has inverse relation with level of interest which means that if supply of money increases, interest level will fall, in result investment level will rise and more output of goods and services will be generated and price level will remain same or even fall.

Conclusion

This theory was flopped in great depression of 1930 when demand and price level of goods fell down and there was an unemployment experienced by most of economies. To tackle this situation, supply of money increased but this measure did not help to tackle the situation.

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