Quantity theory of money (Fisher’s equation of money)

The quantity theory of money (Fisher’s equation of money)

The quantity theory of money is an old theory of economics. It was first propounded by an Italian economist Davanzatti. Later on, it was popularized by the well-known economist Irving Fisher in his book, “The purchasing power of money” published in 1911 AD.

According to Fisher,” Other things being equal, as the quantity of money In circulation increases, the price level also increases in direct proportion and the value of money decreases and vice-versa.”

Assumptions of the Quantity Theory of Money

1. There is no change in the total volume of trade (T), the velocity of circulation of money (V), and bank money.

2. Money is only a medium of exchange and there is no existence of a barter system.

3. There is a constant relationship between banks and currency money.

4. There is full employment of money.

5. The price level is a passive variable.

To explain this theory, fisher has developed the following equation of exchange:-

MV = Pt

Where,

P= price level

M= total amount of money in circulation

V= velocity in circulation of money

T= total volume of transactions or trade

Alternatively, the above equation can be presented as

P = Mv/ T

The above equation explains that when the number of money doubles, the price level will also be double and vice-versa.

It can be presented with the help of the following diagram.

In the above figure, x represents the quantity of money, and the y-axis represents the price level and value of money respectively. When the quantity of money OM, the price level is at OP and the value of money is OV. When the quantity of money increases from om to om1 and OM2; the price level inclines at OP1 and then at OP2 which consequently decreases the value of money from or to OV1 and then to OV2. The first figure shows the positive relationship between the quantity of money and the price level. The second figure shows the relationship between the quantity of money and the value of money. Both price level and value of money are the functions of the quantity of money. Both price level and value of money are the same functions of the quantity of money in circulation.

Criticisms of the Quantity Theory of Money

1. BASED ON UNREALISTIC ASSUMPTIONS

This theory is based on the unrealistic assumption of long period and full employment. The problems of the short period and full employment is an imaginary concept.

2. STATIC THEORY

This theory assumes that the value of money and technology remain constant but in reality, those variables do not remain constant. During the boom phase, they increase and during the depression phase, they decrease.

3. MONEY IS NOT ONLY A MEDIUM OF EXCHANGE

This theory assumes that money is only a medium of exchange and completely excludes other functions of money like a store of value, a measure of value, etc.

4. IGNORES OTHER DETERMINANTS OF THE PRICE LEVEL

This theory assumes that price level is determined only by factors M, V, and T. It ignores other factors like saving, expenditure, population, income, investment, etc.

5. NOT INDEPENDENT VARIABLES

This theory assumes that all the four variables M, V, P, and T are independent. But in reality, all these variables are dependent on each other. The change in one variable affects the other variables.