Lesson 13: Fisher’s Quantity theory of money

Objectives:

After studying this lesson, you will be able to understood,

• The defination of demand for money

• The different approaches to demand for money
• The difference between quantitative approach and demand for money approach
• Fisher’s equation

13.1 Introduction

13.2 Classical approach to demand for money

13.3 Summary

13.4 Check your progress

13.5 Key concepts

13.6 Self Assessment questions

13.7 Answers to check your progress

13.8 Suggested Readings

13.1 Introduction:

Dear student in an earlier chapters you have studied the definition of money and RBI
classification of money. In the present chapter you learn about the concept of demand for
money and classical approach for money. Demand for money is a prominent issue in
macroeconomics due to the important role that demand for money plays in the
determination of the price level, interest income. But, first we should know the meaning
of demand for money. In general demand for money by people is to make payments for
their day-to-day purchases of goods and services. Further, demand for money arises from
two important functions of money. The first is that money acts as a medium of exchange
and the second is a store of value. Thus, individuals and businessman wish to hold money
partly in cash and partly in the form of assets. Theoretically, speaks, various schools of
thought in economics define differently the demand for money. In-fact, people’s demand
for money is not for nominal money holdings but real money balances, because if people
are merely concerned with nominal money holdings irrespective of the price level, they
said to suffer from money illusion.

In the theory, till recently, there were three approaches to demand for money, namely,
transactions approach or Fisher’s quantity theory of money, cash balances approach or
Cambridge equation and, Keynes theory of liquidity preference. However, in recent
years Baumol, Tobin and Friedman also have put forward new theories of demand for
money.

13.2 Classical Approach to demand for Money or Fisher’s Equation:

The classical economists did not explicitly formulate demand for money theory, but their
views are inherent in the quantity theory of money. They considered only the medium of
exchange function of money as an important one i.e., money as a means of purchasing
of goods and services. The cash transactions approach was popularised by Irving Fisher
of the USA in 1911, in his book ‘Purchasing Power of Money’. Through his equation of
exchange he made an attempt to determine price level and value of money.
Symbolically, Fisher’s equation of exchange is written as under

M’V’+ MV = PT --------(1)

Where M is the total quantity of money, M’ is the credit money, V & V’ is its velocity of
circulation of money and credit, ‘P’ is the price level and, ‘T’ is the total amount of
goods and services exchanged for money. This equation equates the demand for money
(PT) to supply of money (MV). As mentioned earlier, he made an attempt to determine
price level and value of money. Value of money is meant by purchasing power of money.
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:

MV + M’V’
P = --------------
T
As per the equation, price is positively associated with money supply, and negatively
influenced by the changes in T and value of money is also determined by the same
variables but it has negative association with M and the direct relation with T. In other
words, 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 one half reduces the quantity of money,
one half will also reduce the price level and the value of money will be twice. The same
theory is explained with the help of fig.
Panel A of fig shows the positive effect of the quantity of money on the price level and in
panel B, the inverse relation between the quantity of money and the value of money is
presented. Panel A depicts that the increase in quantity of money from “OM” to “OM2”
price increases from “OP” to OP2” it shows the positive effect of money on price level.
The indifference curve which is slopes downward from left to right in panel B depicts
that the increase in quantity of money from “M” to “M4” leads to decline in the value of
money from 1/p to 1/p4. which shows the negative association between the quantity of
money and value of money.

However, by taking some assumptions about the variables V & T Fisher

transformed the quantity theory equation into a theory of demand for money.

According to Fisher, the nominal quantity of money is fixed by the central bank and is
therefore, treated as an exogenous variable which is assumed to be a given quantity in a
particular period of time. Further, the number of transactions in a period is a function of
national income. Since, Fisher assumed full employment of resources prevailed in the
economy, the level of national income is determined by the amount of the fully employed
resources. Thus, with this assumption, the volume of transactions T is fixed in short run.
Fisher made most important assumption which makes his equation as a theory of demand
for money is that, velocity of circulation (V) remains constant and is independent of M, P
and T. this is because he thought that velocity of circulation of money (V) is determined
by institutional & technological factors involved in the transaction process.

If we want to be in equilibrium, nominal quantity of money supply must be equal to the

nominal quantity of money demand. So that,

Ms = Md = M------(2)

Where M is fixed by central Bank.

With the above assumptions Fishers equation can be rewritten as

PT 1. PT
MD = ----- or MD = ------- --------------(3)
V V

Therefore, according to Fisher, demand for money is depends on the following three
factors: 1) The number of Transactions 2) The average price transfers 3) The velocity of
circulation of money.

This approach is faced some serious difficulties in empirical research. They are:

1) In this approach transactions are not only purchase of goods and services but also
purchase of capital assets, so that when there is a scope for frequent changes in
capital assets, it is not appropriate to assume that T will remain constant even if Y is
taken to be constant due to full employment assumption
2) It is difficult to define and determine a general price level that covers not only
current goods and services but also capital assets.

13.3 Summary

Quantity theory of money seeks to explain the value of money in terms of changes in its
quantity. In other words, quantity theory of money says that the level of prices varies
directly with quantity of money. In this regard there are three theories, one is cash
transactions theory which was developed by considering medium of exchange is a
function of money. This theory developed by Irving Fisher therefore on his name we
called it as a fisher’s equation. This equation equates the demand for money to supply of
money and he made an attempt to determine price level and value of money in his theory.
According to his there is a positive effect of the quantity of money on the price level and
the inverse relation between the quantity of money and the value of money. This
approach is faced some serious difficulties in empirical research. In this approach
transactions are not only purchase of goods and services but also purchase of capital
assets, so that when there is a scope for frequent changes in capital assets, it is not
appropriate to assume that Transactions will remain constant even if income is taken to
be constant due to full employment assumption. It is difficult to define and determine a
general price level that covers not only current goods and services but also capital assets.

13.4 Check your progress

State whether the following statements are true or false

a) Cash transactions approach also known as fisher’s equation of exchange

b) According to Fisher, demand for money is depends the supply of money.

c) The purchasing power of money depends on the existing price level

 d) The quantity theory states the there is a positive association between money
supply and changes in price.

13.5 Key concepts

Quantity theory of money

Velocity of circulation
Cash balances
Demand for money
Price transfers

13.6 Self Assessment questions

Short Answer type questions:

a) what are the essentials of the Fisher’s Quantity theory?

b) What are determinants of demand for money?

Essay type questions:

a) Critically evaluate the classical approach to money?

b) Critically examine the quantity theory of money?

13.7 Answers to check your progress

a) True b) false c) True d) True e) false

13.8 Suggested Readings

Ackley Gardner : Macro economic theory

Ward R A: Monetary theory and policy
Rana & Verma : Macro economic analysis
Hajela TN: Monetary economics
Ghatak : Monetary economics in developing economies