The Fishers Quantity Theory of Money (Assumptions and Criticisms)

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 eactly proportionate change in
the price level.
Money
!n the "ords of !rving Fisher# $%ther 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.& !f the quantity of money is dou'led# the price level "ill also
dou'le and the value of money "ill 'e one half. %n the other hand# if
the quantity of money is reduced 'y one half# the price level "ill also
'e reduced 'y one half and the value of money "ill 'e t"ice.
Fisher has eplained his theory in terms of his equation of echange(
)T*M+, M +
-here ) * price level# or . !) * the value of money/
M * the total quantity of legal tender money/
+ * the velocity of circulation of M/
M 0 the total quantity of credit money/
+ * the velocity of circulation of M/
T * the total amount of goods and services echanged for money or
transactions performed 'y money.
This equation equates the demand for money ()T) to supply of money
(M+*M+). The total volume of transactions multiplied 'y the price
level ()T) represents the demand for money.
According to Fisher# )T is 1)Q. !n other "ords# price level ()) multiplied
'y quantity 'ought (Q) 'y the community (1) 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 + plus the total quantity of credit money M and its velocity
of circulation +. Thus the total value of purchases ()T) in a year is
measured 'y M+,M+. Thus the equation of echange is )T*M+,M+.
!n order to 2nd out the e3ect of the quantity of money on the price
level or the value of money# "e "rite the equation as
)* M+,M+
T
Fisher points out the price level ()) (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 dou'led# "hile +# + and T remain constant# ) is
also dou'led# 'ut the value of money (.4)) is reduced to half.
Fishers quantity theory of money is eplained "ith the help of Figure
56... (A) and (7). )anel A of the 2gure sho"s the e3ect of changes in
the quantity of money on the price level. To 'egin "ith# "hen the
quantity of money is M# the price level is ).
-hen the quantity of money is dou'led to M8# the price level is also
dou'led to )8. Further# "hen the quantity of money is increased four9
fold to M:# the price level also increases 'y four times to ):. This
relationship is epressed 'y the curve ) * f (M) from the origin at :6;.
!n panel < of the 2gure# the inverse relation 'et"een the quantity of
money and the value of money is depicted "here the value of money is
ta=en on the vertical ais. -hen the quantity of money is M. the value
of money is >). 7ut "ith the dou'ling of the quantity of money to M8#
the value of money 'ecomes one9half of "hat it "as 'efore# .4)8. And
"ith the quantity of money increasing 'y four9fold to M:# the value of
money is reduced 'y .4):. This inverse relationship 'et"een the
quantity of money and the value of money is sho"n 'y do"n"ard
sloping curve .4) * f (M).
Assumptions of the Theory(
Fishers theory is 'ased on the follo"ing assumptions(
.. ) is passive factor in the equation of echange "hich is a3ected 'y
the other factors.
8. The proportion of M to M remains constant.
?. + and + are assumed to 'e constant and are independent of
changes in M and M.
:. T also remains constant and is independent of other factors such as
M# M# + and +.
6. !t is assumed that the demand for money is proportional to the value
of transactions.
5. The supply of money is assumed as an eogenously determined
constant.
@. The theory is applica'le in the long run.
A. !t is 'ased on the assumption of the eistence of full employment in
the economy.
Criticisms of the Theory(
The Fisherian quantity theory has 'een su'Bected to severe criticisms
'y economists.
.. Truism(
According to Ceynes# $The quantity theory of money is a truism.&
Fishers equation of echange is a simple truism 'ecause it states that
the total quantity of money (M+,M+) paid for goods and services
must equal their value ()T). 7ut it cannot 'e accepted today that a
certain percentage change in the quantity of money leads to the same
percentage change in the price level.
8. %ther things not equal(
The direct and proportionate relation 'et"een quantity of money and
price level in Fishers equation is 'ased on the assumption that $other
things remain unchanged&. 7ut in real life# +# + and T are not constant.
Moreover# they are not independent of M# M and ). Dather# all
elements in Fishers equation are interrelated and interdependent. For
instance# a change in M may cause a change in +.
Consequently# the price level may change more in proportion to a
change in the quantity of money. 1imilarly# a change in ) may cause a
change in M. Dise in the price level may necessitate the issue of more
money. Moreover# the volume of transactions T is also a3ected 'y
changes in ). -hen prices rise or fall# the volume of 'usiness
transactions also rises or falls. Further# the assumptions that the
proportion M to M is constant# has not 'een 'orne out 'y facts. Eot
only this# M and M are not independent of T. An increase in the volume
of 'usiness transactions requires an increase in the supply of money
(M and M).
?. Constants Delate to Fi3erent Time(
)rof. >alm criticises Fisher for multiplying M and + 'ecause M relates to
a point of time and + to a period of time. The former is a static concept
and the latter a dynamic. !t is therefore# technically inconsistent to
multiply t"o non9compara'le factors.
:. Fails to Measure +alue of Money(
Fishers equation does not measure the purchasing po"er of money
'ut only cash transactions# that is# the volume of 'usiness transactions
of all =inds or "hat Fisher calls the volume of trade in the community
during a year. 7ut the purchasing po"er 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.
6. -ea= Theory(
According to Cro"ther# the quantity theory is "ea= in many respects.
First# it cannot eplain "hy there are Guctuations in the price level in
the short run. 1econd# it gives undue importance to the price level as if
changes in prices "ere 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.
)rices may not rise despite increase in the quantity of money during
depression/ and they may not decline "ith reduction in the quantity of
money during 'oom. Further# lo" prices during depression are not
caused 'y shortage of quantity of money# and high prices during
prosperity are not caused 'y a'undance of quantity of money. Thus#
$the quantity theory is at 'est an imperfect guide to the causes of the
trade cycle in the short period& according to Cro"ther.
5. Eeglects !nterest Date(
%ne of the main "ea=nesses of Fishers quantity theory of money is
that it neglects the role of the rate of interest as one of the causative
factors 'et"een money and prices. Fishers equation of echange is
related to an equili'rium situation in "hich rate of interest is
independent of the quantity of money.
@. Hnrealistic Assumptions(
Ceynes in his Ieneral 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 'ecause it analyses the relation 'et"een
M and ) in the long run. Thus it neglects the short run factors "hich
inGuence this relationship. 1econd# Fishers equation holds good under
the assumption of full employment. 7ut Ceynes regards full
employment as a special situation. The general situation is one of the
under9employment equili'rium. Third# Ceynes does not 'elieve that the
relationship 'et"een the quantity of money and the price level is direct
and proportional.
Dather# it is an indirect one via the rate of interest and the level of
output. According to Ceynes# $1o long as there is unemployment#
output and employment "ill change in the same proportion as the
quantity of money# and "hen there is full employment# prices "ill
change in the same proportion as the quantity of money.& Thus Ceynes
integrated the theory of output "ith value theory and monetary theory
and criticised Fisher for dividing economics $into t"o compartments
"ith no doors and "indo"s 'et"een the theory of value and theory of
money and prices.&
A. + not Constant(
Further# Ceynes pointed out that "hen there is underemployment
equili'rium# the velocity of circulation of money + is highly unsta'le
and "ould change "ith changes in the stoc= of money or money
income. Thus it "as unrealistic for Fisher to assume + to 'e constant
and independent of M.
J. Eeglects 1tore of +alue Function(
Another "ea=ness of the quantity theory of money is that it
concentrates on the supply of money and assumes the demand for
money to 'e constant. !n order "ords# it neglects the store9of9value
function of money and considers only the medium9of9echange
function of money. Thus the theory is one9sided.
.K. Eeglects Deal 7alance L3ect(
Fon )atin=in has critcised Fisher for failure to ma=e use of the real
'alance e3ect# that is# the real value of cash 'alances. A fall in the
price level raises the real value of cash 'alances "hich leads to
increased spending and hence to rise in income# output and
employment in the economy. According to )atin=in# Fisher gives undue
importance to the quantity of money and neglects the role of real
money 'alances.
... 1tatic(
Fishers theory is static in nature 'ecause of its such unrealistic
assumptions as long run# full employment# etc. !t is# therefore# not
applica'le to a modern dynamic economy
Quantity theory of money is one of the important part of macro
economics. 1ince money matters has more important. The theory has
long age as money. Actually the initial feeds of the theory "as
introduced 'y da"an Matti an !talian economist in .6AA. Nater the
theory "as modi2ed 'y di3erent economists li=e !rvin 2sher# ac pique
and B.m Ceynes till the 8Kth century. Any ho"# no" Quantity theory of
money has t"o versions
. 0 cash transaction approach
8 0 cash 'alance approach
Lach of them are descri'ed 'rieGy as 'elo"
. 0 cash transaction approach
Cash transaction approach of quantity theory of money "as developed
'y )rofessor( !rvin Fisher. >e also introduced a equation to eplain the
theory. 1o# it is also =no"n as Fishers equation of echange. 1imply
the theory dealing "ith the relationship 'et"een supply of money and
price level. !n short# the theory states O any changes in the supply of
the money "ill 'e resulted in the same proportional change in the price
level. -hich means "hen quantity of the supply of money increases
the price level also increase. That is a positive relation 'et"een
quantity of money supply and price level. Further the theory also
states that O any changes in the quantity of the supply of money "ill
inversely a3ect the value of money. -hich means "hen the money
supply increases the value of money "ill decrease. 1o there is a
negative relationship 'et"een quantity of money supply and the value
of money.
Lquation of the theory 'y )rofessor( !rvin Fisher
To eplain the theory# )rofessor( !rvin Fisher introduced a equation
popularly =no"n as the Oequation of echange# the equation is
alge'raically sho"ing 'elo".
M+ * )T
!n the equation M * quantity of money
+ * velocity of money
) * general price level
T * total volume of transaction
+elocity of money ( 9 velocity of money refers to the total num'er of
times the money is circulated in an economy or the num'er of times#
the money is changes from hands to hands
!n the left hand side of the equation (M+)# is the supply of money and
the right hand side of the equation ()T)# is the demand for money.
To eplain the theory "e assume that# + and T in the equation are
constant. Then quantity of money (M) is vary directly "ith price level
()). Any "ay in summary the theory suggest t"o maBor facts occurring
in an economy due to changes in the quantity of money supply. They
are
A 0 "hen money supply increases the price level also in increases ( "ill
dou'led)
7 0 "hen money supply increases the value of money "ill decrease
( "ill 'ecome half )
Fiagrammatic representation of the theory
The transaction approach of the theory can 'e represented as sho"ing
in the graph 'elo".
!n 2gure .# the total quantity of output is represented on the O ais
and the price level on the Oy ais. And consider the quantity of output
is constant at the level of OQ. And M1. is the initial supply curve of
money M. is the quantity of supply of money. -here the price level is
).. then suppose# an increase in the supply of money from M. to M8#
then the price level also increased 'y )8 from ).. !t sho"ing a direct
relationship 'et"een quantity of money supply and the price level.
8 0 Cash 'alance approach
This is the second version of the quantity theory of money. Actually the
maBor contri'ution to the development of the cash 'alance approach
la'elled in the name of famous economist A.C. )ique. The cash 'alance
approach is eplained "ith the help of the Cam'ridge equation. 1o# the
cash 'alance approach is also called as Cam'ridge version. The
signi2cance of the Cam'ridge version is it is not only considered on the
supply of money 'ut also focuses on the demand for money.
The Cam'ridge equation derived from the same equation of echange#
that is M+*)T. Then the equation is solving for M# then "e "ill get
M * )T4+
The equation can 'e re"rite as given 'elo".
M * .4+ P )T
For simplicity "e can ta=e O= in the place of .4+. 1o# the equation
'ecome
M * C)T
!n the equation M * money supply
) * price level
T * total volume of transaction
C* the demand for money the people "ant to held in hand
1ince# C is equal to .4+ the velocity of money and the demand for
money as a store of value is inversely related. !n simple "ords the
people demand money to held in hand is inversely related "ith the
velocity of money.
Conclusion
Quantity theory of money is one of the most important theory in
Lconomics dealing "ith the relationship 'et"een supply of money and
price level# value of money etc. the theory stating that there is a direct
and proportionate relation can 'e see 'et"een supply of money and
price level# and a indirect relationship 'et"een supply of money and
the value of money.
!n short# no"# quantity theory of money has t"o versions# namely cash
transaction approach and the cash 'alance approach. The cash
transaction approach emphasiMes on the supply of money "hile the
cash 'alance approach highlights the demand for money.
Ceynesian +ie" on Quantity Theory of Money
Ceynes reformulated the quantity theory of money introduced 'y
classical economists "hich "as 'ased on the assumption of full
employment. According to quantity theory of money money supply and
price level are vary in a direct "ay in a certain proportion. 7ut later# Q.M
Ceynes reformulated the same quantity theory of money 'y adding the
theory of interest.
CeynesianRs vie" "as 'ased on many assumptions as sho"ing 'elo".
a) the factors of productions are perfectly elastic and there eist
unemployment in the economy.
') All unemployed factors of production are homogenous in nature#
that is one factor can use instead of other factor.
c) And all these factors are 'ased on the Constant Deturn to 1cale.
-hen a certain percentage of factor input increased# it "ill give same
proportionate increase in the output.
7ased on this assumptions# Ceynes argue that# the increasing of money
supply resulted in the reduction of interest. %nce the interest rate is
declined# people invest their money (capital formation) instead of
depositing "ith 'an=. Iradually the increasing of investment reduce
the unemployment and increase the income. 1ince the factors of
production are 'ased on Constant Deturn to 1cale# there is no
possi'ility to increase the price of the commodity. And there is no any
chance for raising the price proportionate to raising money supply. !n
short# after the full employment is attained (all resources are utiliMed)
the increasing money supply varies directly "ith price level.