The Real Quantity Of Money Is Defined
Quantity Of Money Demanded Formula
The Quantity Of People

Print Economics of Money: Chapter 19 flashcards Easy Notecards. The quantity theory of money is a theory of how. A) the money supply is determined. B) interest rates are determined. C) the nominal value of aggregate income is determined. D) the real value of aggregate income is determined. The theory explaining the direct relationship between the price level and quantity of money is known as: (A) Quantity theory of money (B) Say’s law of markets (C) Real theory of interest (D) None of these 7. In classical theory the level of employment is a function of: (A) Price level (B) Money wage rate (C) Quantity of money (D) Real. The theory explaining the direct relationship between the price level and quantity of money is known as: (A) Quantity theory of money (B) Say’s law of markets (C) Real theory of interest (D) None of these 7. In classical theory the level of employment is a function of: (A) Price level (B) Money wage rate (C) Quantity of money (D) Real.

In this article we will discuss about:- 1. Fisher’s Equation of Exchange 2. Assumptions of Fisher’s Quantity Theory 3. Conclusions 4. Criticisms 5. Merits 6. Implications 7. Examples.

Fisher’s Equation of Exchange:

The transactions version of the quantity theory of money was provided by the American economist Irving Fisher in his book- The Purchasing Power of Money (1911). According to 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”.

Fisher’s quantity theory is best explained with the help of his famous equation of exchange:

ADVERTISEMENTS:

MV = PT or P = MV/T

Like other commodities, the value of money or the price level is also determined by the demand and supply of money.

i. Supply of Money:

The supply of money consists of the quantity of money in existence (M) multiplied by the number of times this money changes hands, i.e., the velocity of money (V). In Fisher’s equation, V is the transactions velocity of money which means the average number of times a unit of money turns over or changes hands to effectuate transactions during a period of time.

Thus, MV refers to the total volume of money in circulation during a period of time. Since money is only to be used for transaction purposes, total supply of money also forms the total value of money expenditures in all transactions in the economy during a period of time.

ii. Demand for Money:

Money is demanded not for its own sake (i.e., for hoarding it), but for transaction purposes. The demand for money is equal to the total market value of all goods and services transacted. It is obtained by multiplying total amount of things (T) by average price level (P).

Thus, Fisher’s equation of exchange represents equality between the supply of money or the total value of money expenditures in all transactions and the demand for money or the total value of all items transacted.

ADVERTISEMENTS:

Supply of money = Demand for Money

Total value of money expenditures in all transactions = Total value of all items transacted

MV = PT

P = MV/T

Where,

M is the quantity of money

V is the transaction velocity

ADVERTISEMENTS:

P is the price level.

T is the total goods and services transacted.

The equation of exchange is an identity equation, i.e., MV is identically equal to PT (or MV = PT). It means that in the ex-post or factual sense, the equation must always be true. The equation states the fact that the actual total value of all money expenditures (MV) always equals the actual total value of all items sold (PT).

What is spent for purchases (MV) and what is received for sale (PT) are always equal; what someone spends must be received by someone. In this sense, the equation of exchange is not a theory but rather a truism.

Irving Fisher used the equation of exchange to develop the classical quantity theory of money, i.e., a causal relationship between the money supply and the price level. On the assumptions that, in the long run, under full-employment conditions, total output (T) does not change and the transactions velocity of money (V) is stable, Fisher was able to demonstrate a causal relationship between money supply and price level.

In this way, Fisher concludes, “… the level of price varies directly with the quantity of money in circulation provided the velocity of circulation of that money and the volume of trade which it is obliged to perform are not changed”. Thus, the classical quantity theory of money states that V and T being unchanged, changes in money cause direct and proportional changes in the price level.

Irving Fisher further extended the equation of exchange so as to include demand (bank) deposits (M’) and their velocity, (V’) in the total supply of money.

Thus, the equation of exchange becomes:

ADVERTISEMENTS:

Thus, according to Fisher, the level of general prices (P) depends exclusively on five definite factors:

(a) The volume of money in circulation (M);

(b) Its velocity of circulation (V) ;

(d) Its velocity of circulation (V’); and

(e) The volume of trade (T).

The transactions approach to the quantity theory of money maintains that, other things remaining the same, i.e., if V, M’, V’, and T remain unchanged, there exists a direct and proportional relation between M and P; if the quantity of money is doubled, the price level will also be doubled and the value of money halved; if the quantity of money is halved, the price level will also be halved and the value of money doubled.

Example:

Fisher’s quantity theory of money can be explained with the help of an example. Suppose M = Rs. 1000. M’ = Rs. 500, V = 3, V’ = 2, T = 4000 goods.

Thus, when money supply in doubled, i.e., increases from Rs. 4000 to 8000, the price level is doubled. i.e., from Re. 1 per good to Rs. 2 per good and the value of money is halved, i.e., from 1 to 1/2.

Thus, when money supply is halved, i.e., decreases from Rs. 4000 to 2000, the price level is halved, i.e., from 1 to 1/2, and the value of money is doubled, i.e., from 1 to 2.

The effects of a change in money supply on the price level and the value of money are graphically shown in Figure 1-A and B respectively:

(i) In Figure 1-A, when the money supply is doubled from OM to OM₁, the price level is also doubled from OP to OP₁. When the money supply is halved from OM to OM₂, the price level is halved from OP to OP₂. Price curve, P = f(M), is a 45° line showing a direct proportional relationship between the money supply and the price level.

(ii) In Figure 1-B, when the money supply is doubled from OM to OM_1; the value of money is halved from O1/P to O1/P₁ and when the money supply is halved from OM to OM₂, the value of money is doubled from O1/P to O1/P₂. The value of money curve, 1/P = f (M) is a rectangular hyperbola curve showing an inverse proportional relationship between the money supply and the value of money.

Fisher’s Equation of Exchange:

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The Real Quantity Of Money Is