Quantity Theory Of Money By Irving Fisher
Irving Fisher an American economist, put forward the Cash Transaction Approach to the quantity theory of money. He in his book The Purchasing Power of Money (1911) has stated that the value of money in a given period of time depends upon the quant t money in circulation in the economy It is the quantity of money which determines t general price level and the value of money Any change in the money supply directly affects the general price level and the value of money inversely in the same proportion In Fisher s words, “Other things remaining unchanged, 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”. For example, if the quantity of money in circulation is doubled other things being equal the general price level will be doubled and the value of money is halved. Similarly if the quantity of money is halved the price level will behave and the value of money doubled.
In Fisher’s Cash Transactions Version of Money, the general price level in a country, like the prices of commodities, is determined by the supply of and demand for money.
(a) Supply of Money: The supply of money consists of the quantity of money in circulation (M) and the velocity of its circulation (V) i.e., the number of times the money changes hands. Thus MV refers to the total volume of money in circulation during a period of time. For example, if the total money supply in Pakistan Rs. 5,000 billion and its velocity per unit of time is 10 times, then the total money supply would be Rs. 5,000 x 10 = Rs.50000 billion.
(b) Demand for Money: People demand money not for its own sake. They demand money because it serves a medium of exchange. It is used to carry every day transactions. In short, the demand for money is for the exchange of goods.
Equation of Exchange:
The Cash transaction version of the quantity theory of money was presented by lrving fisher in the form of an equation:
P = MV + M1 V1 or PT= MV+ M1V1
P is the price Level
M is the quantity of money
V is the velocity of circulation of M
M1 is the volume of credit money
V1 is the velocity of circulation of M1
T is the total volume of goods and Trade
The Irving Fisher’s quantity theory of money can be explained by taking an example. Let us suppose M = Rs. 2000, M1 is Rs = 1000, V = 6, V1 = 4 and T = 8000 goods.
Thus when the money supply is doubled the price level is doubled i.e., the price of good rises from Rs. 2 to Rs. 4 per unit and the value of money is halved = Rs. 2
The direct and proportionate relationship between the supply of money- and the general price level is explained with the help of figure 4. 1:
In figure 4.1 (a) it is shown that when the supply of money is increased from QM to QM2, the price level also rises from OP1 to OP2. As the quality of money increase four times to QM4, the price level also increases four times to OP4.
In figure 4.1(b) the inverse relationship between quantities of money in circulation and the value of money is shown. When the quantity of money is QM1, the value of money is VM1. When the money supply is doubled from QM1 to QM2, the value of money is reduced to half from VM1 to VM2.
Assumptions of the theory
(1) Full employment: The theory is based on the assumption of full employment in the economy
(2) T and V are constant: The theory assumes that volume of trade (T) ii the short run remains constant. So is the case with velocity of money (V) which remains unaffected.
(3) Constant relation between M and M1. Fisher assumes constant relation between currency money M and credit money (M1).
(4) Price level (P) is a passive factor. The price level (P) is inactive or passive in the equation. P is affected by other factors in equation i.e., T, M, M1, V and V1 but it does not affect them.
Criticism of the theory
The quantity theory s subjected to the following criticism.
(1) Unrealistic assumptions: The theory is based on unrealistic assumptions. In this theory P is considered as a passive factor. T is independent. M1, V, V1, are constant in the short run. All these assumptions are covered under “Other things remaining the same.” In actual working of the economy,
these do not remain constant; Hence, the theory is unrealized and misleading.
(2) Various Variables in the transaction are not independent. The various variables in transaction eqi4ation are not independent as assumed in the theory The fact is that they very much influence each other For example when money supply (M) increases the velocity f money (V) also goes up Take an other case. Fisher assumes (P) is a passive factor and has no effect on trade (T). In actual practice, when price level P) rises, it increases profits and promotes trade (T).
(3) Assumption of full employment is wrong. J. M. Keynes has raised en objection that the assumption of full employment is a rare phenomenon in the economy and the theory is not real.
(4) Rate of interest ignored. In the quantity theory of Fishers, the influence of the rate of interest on the money supply and the level of prices have been completely ignored. The fact is that an increase or decrease in money supply has an important bearing on the rate: of interest. An increase in money supply leads to a decline in the rate of interest and vice versa.
(5) Fails to explain trade cycles. The theory fails to explain the trade cycles. It does not tell as to why during depression, the increase in money supply has little impact on the price level, Similarly, in boom period the reduction in money supply or tight money policy may not bring down the price level G. Crowther is right in saying, “The quantity theory is at best an imperfect guide to the cause of the business cycle”.
(6) Ignores other factors of price level. There are many determinants other than M, V, and T which have important implication on the price level. These factors such as income, expenditure, saving, investment, population consumption etc have been ignored from the purview of the theory.