Fisher's quantity theory of money
Posted by Ripon Abu Hasnat on Tuesday, February 17, 2015 | 0 comments
The
quantity theory of money states that the quantity of money is the main
determinant of the price level or the value of money. Any change in the
quantity of money produces an exactly proportionate change in the price level.
In
the words of Irving Fisher, “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.” If the quantity of
money is doubled, the price level will also double and the value of money will
be one half. On the other hand, if the quantity of money is reduced by one
half, the price level will also be reduced by one half and the value of money
will be twice.
Fisher
has explained his theory in terms of his equation of exchange:
PT=MV+
M’ V’
Where
P = price level, or 1 IP = the value of money;
M
= the total quantity of legal tender money;
V
= the velocity of circulation of M;
M’
– the total quantity of credit money;
V’
= the velocity of circulation of M;
T
= the total amount of goods and services exchanged for money or transactions
performed by money.
This
equation equates the demand for money (PT) to supply of money (MV=M’V). The
total volume of transactions multiplied by the price level (PT) represents the
demand for money.
According
to Fisher, PT is SPQ. In other words, price level (P) multiplied by quantity
bought (Q) by the community (S) gives the total demand for money. This equals
the total supply of money in the community consisting of the quantity of actual
money M and its velocity of circulation V plus the total quantity of credit
money M’ and its velocity of circulation V’. Thus the total value of purchases
(PT) in a year is measured by MV+M’V’. Thus the equation of exchange is
PT=MV+M’V’. In order to find out the effect of the quantity of money on the
price level or the value of money, we write the equation as
PT=
MV+M’V’
Fisher
points out the price level (P) (M+M’) provided the volume of tra remain
unchanged. The truth of this proposition is evident from the fact that if M and
M’ are doubled, while V, V and T remain constant, P is also doubled, but the
value of money (1/P) is reduced to half.
Fisher’s
quantity theory of money is explained with the help of Figure 65.1. (A) and
(B). Panel A of the figure shows the effect of changes in the quantity of money
on the price level. To begin with, when the quantity of money is M, the price
level is P.
When
the quantity of money is doubled to M2, the price level is also
doubled to P2. Further, when the quantity of money is increased
four-fold to M4, the price level also increases by four times to P4.
This relationship is expressed by the curve P = f (M) from the origin at 45°.
In
panel В
of the figure, the inverse relation between the quantity of money and the value
of money is depicted where the value of money is taken on the vertical axis.
When the quantity of money is M1 the value of money is HP. But with
the doubling of the quantity of money to M2, the value of money
becomes one-half of what it was before, 1/P2. And with the quantity
of money increasing by four-fold to M4, the value of money is
reduced by 1/P4. This inverse relationship between the quantity of
money and the value of money is shown by downward sloping curve 1/P = f (M).
Assumptions of the Theory:
Fisher’s
theory is based on the following assumptions:
1.
P is passive factor in the equation of exchange which is affected by the other
factors.
2.
The proportion of M’ to M remains constant.
3.
V and V are assumed to be constant and are independent of changes in M and M’.
4.
T also remains constant and is independent of other factors such as M, M, V and
V.
5.
It is assumed that the demand for money is proportional to the value of transactions.
6.
The supply of money is assumed as an exogenously determined constant.
7.
The theory is applicable in the long run.
8.
It is based on the assumption of the existence of full employment in the
economy.
Criticisms of the Theory:
The
Fisherian quantity theory has been subjected to severe criticisms by
economists.
1. Truism:
According
to Keynes, “The quantity theory of money is a truism.” Fisher’s equation of
exchange is a simple truism because it states that the total quantity of money
(MV+M’V’) paid for goods and services must equal their value (PT). But it
cannot be accepted today that a certain percentage change in the quantity of
money leads to the same percentage change in the price level.
2. Other things not equal:
The
direct and proportionate relation between quantity of money and price level in
Fisher’s equation is based on the assumption that “other things remain
unchanged”. But in real life, V, V and T are not constant. Moreover, they are
not independent of M, M’ and P. Rather, all elements in Fisher’s equation are
interrelated and interdependent. For instance, a change in M may cause a change
in V.
Consequently,
the price level may change more in proportion to a change in the quantity of
money. Similarly, a change in P may cause a change in M. Rise in the price
level may necessitate the issue of more money. Moreover, the volume of
transactions T is also affected by changes in P. When prices rise or fall, the
volume of business transactions also rises or falls. Further, the assumptions
that the proportion M’ to M is constant, has not been borne out by facts. Not
only this, M and M’ are not independent of T. An increase in the volume of
business transactions requires an increase in the supply of money (M and M’).
3. Constants Relate to Different
Time:
Prof.
Halm criticises Fisher for multiplying M and V because M relates to a point of
time and V to a period of time. The former is a static concept and the latter a
dynamic. It is therefore, technically inconsistent to multiply two
non-comparable factors.
4. Fails to Measure Value of Money:
Fisher’s
equation does not measure the purchasing power of money but only cash
transactions, that is, the volume of business transactions of all kinds or what
Fisher calls the volume of trade in the community during a year. But the
purchasing power of money (or value of money) relates to transactions for the
purchase of goods and services for consumption. Thus the quantity theory fails
to measure the value of money.
5. Weak Theory:
According
to Crowther, the quantity theory is weak in many respects. First, it cannot
explain ’why’ there are fluctuations in the price level in the short run.
Second, it gives undue importance to the price level as if changes in prices
were the most critical and important phenomenon of the economic system. Third,
it places a misleading emphasis on the quantity of money as the principal cause
of changes in the price level during the trade cycle.
6. Neglects Interest Rate:
One
of the main weaknesses of Fisher’s quantity theory of money is that it neglects
the role of the rate of interest as one of the causative factors between money
and prices. Fisher’s equation of exchange is related to an equilibrium
situation in which rate of interest is independent of the quantity of money.
7. Unrealistic Assumptions:
Keynes
in his General Theory severely criticised the Fisherian quantity theory of
money for its unrealistic assumptions. First, the quantity theory of money for
its unrealistic assumptions. First, the quantity theory of money is unrealistic
because it analyses the relation between M and P in the long run. Thus it
neglects the short run factors which influence this relationship. Second,
Fisher’s equation holds good under the assumption of full employment. But
Keynes regards full employment as a special situation. The general situation is
one of the under-employment equilibrium. Third, Keynes does not believe that
the relationship between the quantity of money and the price level is direct
and proportional.
8. V not Constant:
Further,
Keynes pointed out that when there is underemployment equilibrium, the velocity
of circulation of money V is highly unstable and would change with changes in
the stock of money or money income. Thus it was unrealistic for Fisher to
assume V to be constant and independent of M.
9. Neglects Store of Value Function:
Another
weakness of the quantity theory of money is that it concentrates on the supply
of money and assumes the demand for money to be constant. In order words, it
neglects the store-of-value function of money and considers only the
medium-of-exchange function of money. Thus the theory is one-sided.
10. Neglects Real Balance Effect:
Don
Patinkin has criticized Fisher for failure to make use of the real balance
effect, that is, the real value of cash balances. A fall in the price level
raises the real value of cash balances which leads to increased spending and
hence to rise in income, output and employment in the economy. 11. Static:
Fisher’s
theory is static in nature because of its unrealistic assumptions as long run,
full employment, etc. It is, therefore, not applicable to a modern dynamic
economy.
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