Question

Illustrate Fisher’s Quantity theory of money.

Answer 1

Fisher’s Quantity Theory of Money:
The quantity theory of money is a very old theory. It was first propounded in 1588 by an Italian economist, Davanzatti. But, the credit for popularizing this theory in recent years rightly belongs to the well-known American economist, Irving Fisher who published his book, ‘The Purchasing Power of Money” in 1911. He gave it a quantitative form in terms of his famous “Equation of Exchange”.
The general form of the equation given by Fisher is –
MV = PT

1. Fisher points out that in a country during any given period of time, the total quantity of money (MV) will be equal to the total value of all goods and services bought and sold (PT). MV = PT
   Supply of Money = Demand for Money
2. This equation is referred to as “Cash Transaction Equation”.
   Where M = Money Supply/quantity of Money
   V = Velocity of Money
   P = Price level
   T = Volume of Transaction.
   It is expressed as P = MV/T which implies that the quantity of money determines the price level and the price level in its turn varies directly with the quantity of money, provided ‘V’ and ‘T’ remain constant.
3. According to Marshall, people's desire to hold money (the coefficient, K) is more powerful in the determination of money, rather than quantity of money (M). So, peoples’ desire to hold money is a determinant of the value of money.
4. The above equation considers only currency money. But, in a modem economy, banks demand deposits or credit money and its velocity plays a vital part in business. Therefore, Fisher extended his original equation of exchange to include bank deposits M, and its velocity Vr The revised equation was:
   PT = MV + M₁V₁
   P = `("MV"+"M"_1"V"_1)/"T"`
5. From the revised equation, it is evident, that the price level is determined by (a) the quantity of money in circulation ‘M’ (b) the velocity of circulation of money ‘V’ (c) the volume of bank credit money M₁ (d) the velocity of circulation of credit money V₁, and the volume of trade (T)

Diagramatic Illustration:

Quantity of Money

1. Figure (A) shows the effect of changes in the quantity of money on the price level. When the quantity of money is OM, the price level is OP. When the quantity of money is doubled to OM₂, the price level is also doubled to OP₂. Further, when the quantity of money is increased four-fold to OM₄, the price level also increases by four times to OP₄. This relationship is expressed by the curve OP = f (M) from the origin at 45°.
2. Figure (B), shows the inverse relationship between the quantity of money and the value of money, where the value of money is taken on the vertical axis. When the quantity of money is OM₁, the value of money is 01/P₁. But with the doubling of the quantity of money to OM₂, the value of money becomes one–half of what it was before, (01/P₂). But, with the quantity of money increasing fourfold to OM₄, the value of money is reduced by 01/P₄. This inverse relationship between the quantity of money and the value of money is shown by the downward sloping curve 1/OP = f (M).