Quantity Theory of Money

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:
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.
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.
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.
Supply of money = Demand for Money
Or
Total value of money expenditures in all transactions = Total value of all items transacted
MV = PT
or
P = MV/T
Where,
M is the quantity of money
V is the transaction velocity
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.

Effect of changes in M on P:
The main prediction of the quantity theory of money is that, if V remains constant, any change in
M, effected by the central bank, leads to an exact proportionate change in nominal GDP.
Since real GDP remains constant in the short run when factor supplies remain fixed and
technology (which determines the production function) remains unchanged, any change in
nominal GDP must represent a change in the general price level (P). Thus, according to the
quantity theory of money, the price level (P) is proportional to the money supply (M).
Since the rate of inflation measures the percentage increase in the price level, the quantity theory
which is a theory of the general price level is also a theory of the rate of inflation. The quantity
equation, when expressed in percentage change form, is
% change in M + % change in V = % change in P + % change in Y.
In this equation the second term on both the left hand side and the right hand side are assumed to
remain constant. So the growth in the money supply (which is under the control of the central
bank) determines the rate of inflation. Thus the central bank, which is the central monetary
authority, has ultimate control over the price situation or the rate of inflation.
If the central bank keeps the money supply fixed, the price level will remain stable. If the central
bank increases M very fast, P will rise quite rapidly, as is observed during hyperinflation (when
there is flight from currency).
To sum up, inflation is the rate of increase of the price level. In an economy where GDP does not
rise or fall, the quantity theory of money implies that the price level is proportional to the money
supply. More money simply raises prices. The central bank can choose whatever rate of inflation
it wants just by raising the money supply by that percentage each year.
For price stability the central bank should keep the money supply constant from one year to the
next. For 5% inflation it should raise M by 5%.
In a growing economy, rate of inflation will be less than the rate of money growth. If GDP is
growing overtime some money growth is needed just to keep the price level from falling from
one year to the next.

Assumptions of Fisher’s Quantity Theory:

1. Constant Velocity of Money:
According to Fisher, the velocity of money (V) is constant and is not influenced by the changes
in the quantity of money. The velocity of money depends upon exogenous factors like
population, trade activities, habits of the people, interest rate, etc. These factors are relatively
stable and change very slowly over time. Thus, V tends to remain constant so that any change in
supply of money (M) will have no effect on the velocity of money (V).
2. Constant Volume of Trade or Transactions:
Total volume of trade or transactions (T) is also assumed to be constant and is not affected by
changes in the quantity of money. T is viewed as independently determined by factors like
natural resources, technological development, population, etc., which are outside the equation
and change slowly over time. Thus, any change in the supply of money (M) will have no effect
on T. Constancy of T also means full employment of resources in the economy.
3. Price Level is a Passive Factor:
According to Fisher the price level (P) is a passive factor which means that the price level is
affected by other factors of equation, but it does not affect them. P is the effect and not the cause
in Fisher’s equation. An increase in M and V will raise the price level. Similarly, an increase in T
will reduce the price level.
4. Money is a Medium of Exchange:
The quantity theory of money assumed money only as a medium of exchange. Money facilitates
the transactions. It is not hoarded or held for speculative purposes.
5. Long Period:
The theory is based on the assumption of long period. Over a long period of time, V and T are
considered constant.
Thus, when M’, V, V’ and T in the equation MV + M’Y’ = PT are constant over time and P is a
passive factor, it becomes clear, that a change in the money supply (M) will lead to a direct and
proportionate change in the price level (P).

Broad Conclusions of Fisher’s Quantity Theory:

(i) The general price level in a country is determined by the supply of and the demand for
money.
(ii) Given the demand for money, changes in money supply lead to proportional changes in the
price level.
(iii) Since money is only a medium of exchange, changes in the money supply change absolute
(nominal), and not relative (real), prices and thus leave the real variables such as employment
and output unaltered. Money is neutral.
(iv) Under the equilibrium conditions of full employment, the role of monetary (or fiscal) policy
is limited.
(v) During the temporary disequilibrium period of adjustment, an appropriate monetary policy
can stabilize the economy.
(vi) The monetary authorities, by changing the supply of money, can influence and control the
price level and the level of economic activity of the country.

Criticisms of Quantity Theory of Money:

1. Interdependence of Variables:
The various variables in transactions equation are not independent as assumed by the quantity
theorists:
(i) M Influences V – As money supply increases, the prices will increase. Fearing further rise in
price in future, people increase their purchases of goods and services. Thus, velocity of money
(V) increases with the increase in the money supply (M).
(ii) P Influences T – Fisher assumes price level (P) as a passive factor having no effect on trade
(T). But, in reality, rising prices increase profits and thus promote business and trade.
(iii) P Influences M – According to the quantity theory of money, change in money supply (M) is
the cause and change in the price level (P) is the effect. But, critics maintain that a change in the
price level occurs independently and this later on influences money supply.
(iv) T Influences V – If there is an increase in the volume of trade (T), it will definitely increase
the velocity of money (V).
(v) T Influences M – During prosperity growing volume of trade (T) may lead to an increase in
the money supply (M), without altering the prices.
(vi) M and T are not Independent – According to Keynes, output remains constant only under the
condition of full employment. But, in reality less-than-full employment prevails and an increase
in the money supply increases output (T) and employment.
2. Unrealistic Assumption of Long Period:
The quantity theory of money has been criticized on the ground that it provides a long-term
analysis of value of money. It throws no light on the short-run problems. Keynes has aptly
remarked that “in the long-run we are all dead”. Actual problems are short-run problems. Thus,
quantity theory has no practical value.
3. Unrealistic Assumption of full Employment:
Keynes’ fundamental criticism of the quantity theory of money was based upon its unrealistic
assumption of fall employment. Full employment is a rare phenomenon in the actual world. In a
modern capitalist economy, less than full employment and not full employment is a normal
feature. According to Keynes, as long as there is unemployment, every increase in money supply
leads to a proportionate increase in output, thus leaving the price level unaffected.
4. Static Theory:
The quantity theory assumes that the values of V, V’, M’ and T remain constant. But, in reality,
these variables do not remain constant. The assumption of constancy of these factors makes the
theory a static theory and renders it inapplicable in the dynamic world.
5. Technically Inconsistent:
Prof. Halm considers the equation of exchange as technically inconsistent. M in the equation is a
stock concept; it refers to the stock of money at a point of time. V, on the other hand, is a flow
concept, it refers to velocity of circulation of money over a period of time, M and V are non-
comparable factors and cannot be multiplied together. Hence the left-hand side of the equation
MV = PT is inconsistent.
6. Ignores Other Determinants of Price Level:
The quantity theory maintains that price level is determined by the factors included in the
equation of exchange, i.e. by M, V and T, and unrealistically establishes a direct and
proportionate relationship between the quantity of money and the price level. It ignores the
importance of many other determinates of prices, such as income, expenditure, investment,
saving, consumption, population, etc.
7. Fails to Integrate Monetary Theory with Price Theory:
The classical quantity theory falsely separates the theory of value from the theory of money.
Money is considered neutral and changes in money supply are believed to affect the absolute
prices and not relative prices. Keynes criticizes this view and maintains that money plays an
active role and both the theory of money and the theory of value are essential parts of the general
theory of output, employment and money. He integrated the two theories through the rate of
interest.
8. Money as a Store of Value Ignored:
The quantity theory of money considers money only as a medium of exchange and completely
ignores its importance as a store of value. Keynes recognized the stores of value function of
money and laid emphasis on the demand for money for speculative purpose as against the
classical emphasis on the transactions and precautionary demand for money.
9. One-Sided Theory:
Fisher’s transactions approach is one- sided. It takes into consideration only the supply of money
and its effects and assumes the demand for money to be constant. It ignores the role of demand
for money in causing changes in the value of money.
10. A Redundant Theory:
The critics regard the quantity theory as redundant and unnecessary. In fact, there is no need of a
separate theory of money. Like all other commodities, the value of money is also determined by
the forces of demand and supply of money. Thus, the general theory of value which explains the
value determination of a commodity can also be extended to explain the value of money.

Merits of Quantity Theory of Money:

1. Correct in Broader Sense:
It is true that in its strict mathematical sense (i.e., a change in money supply causes a direct and
proportionate change in prices); the quantity theory may be wrong and has been rejected both
theoretically and empirically. But, in the broader sense, the theory provides an important clue to
the fluctuations in prices. Nobody can deny the fact that most of the changes in the prices of the
commodities are due to changes in the quantity of money.
2. Validity of the Theory:
Till 1930s, the quantity theory of money was used by the economists and policy makers to
explain the changes in the general price level and to form the basis of monetary policy. A
number of historical instances like hyper- inflation in Germany in 1923-24 and in China in 1947-
48 have proved the validity of the theory. In these cases large issues of money pushed up prices.
3. Basis of Monetary Policy:
The theory forms the basis of the monetary policy. Various instruments of credit control, like the
bank rate and open market operations, presume that large supply of money leads to higher prices.
Cheap money policy is advocated during depression to raise prices.
4. Revival of Quantity Theory:
In the recent times, the monetarists have revived the classical quantity theory of money. Milton
Friedman, the leading monetarist, is of the view that the quantity theory was not given full
chance to fight the great depression 1929-33; there should have been the expansion of credit or
money or both.
He believes that the present inflationary rise in prices in most of the countries of the world is
because of expansion of money supply much more than the expansion in real income. The proper
monetary policy is to allow the money supply to grow in line with the growth in the country’s
output.

Implications of Quantity Theory of Money:

1. Proportionality of Money and Prices:
The quantity theory of money leads to the conclusion that the general level of prices varies
directly and proportionately with the stock of money, i.e., for every percentage increase in the
money stock, there will be an equal percentage increase in the price level. This is possible in an
economy – (a) whose internal mechanism is capable of generating a full-employment level of
output, and (b) in which individuals maintain a fixed ratio between their money holdings and
money value of their transactions.
2. Neutrality of Money:
The quantity theory of money justifies the classical belief that money is neutral’ or ‘money is a
veil’ or ‘money does not matter’. It implies that changes in the money supply are neutral in the
sense that they affect the absolute prices and not the relative prices. Since, consumer spending
and business spending decisions depend upon relative prices; changes in the money supply do
not affect real variables such as employment and output. Thus, money is neutral.
3. Dichotomization of the Price Process:
The quantity theory also justifies the dichotomization of the price process by the classical
economists into its real and monetary aspects. The relative (or real) prices are determined in the
commodity markets and the absolute (or nominal) prices in the money market. Since money is
neutral and changes in money supply affect only the monetary and not the real phenomena, the
classical economists developed the theory of employment and output entirely in real terms and
separated it from their monetary theory of absolute prices.
4. Monetary Theory of Prices:
The quantity theory of money upholds the view that the general level of prices is mainly a
monetary phenomenon. The non-monetary factors, like taxes, prices of imported goods,
industrial structure, etc., do not have lasting influence on the price level. These factors may raise
the prices in the short run, but this price rise will reduce actual money balances below their
desired level. This will lead to fall in money spending and a consequent fall in the price level
until the original price is restored.
5. Role of Monetary Policy:
In a self-adjusting free-market economy in which changes in money supply do not affect the real
macro variables of employment and output, there is little room left for a monetary policy. But the
classical economists recognized the existence of frictional unemployment which represents
temporary disequilibrium situation.
Such a situation arises when wages and prices are rigid downward. To me such a situation of
unemployment, the classical economists advocated a stabilizing monetary policy of increasing
money supply. An increase in the money supply increases total spending and the general price
level.
Wage will rise less rapidly (or relative wages will fall) in the labor surplus areas, thereby
reducing unemployment Thus, through a judicious use of monetary policy, the time lag between
disequilibrium and adjustment can shortened; or, in the case of frictional unemployment, the
duration of unemployment can be reduce. Thus, the classical economists assigned a modest
stabilizing role to monetary policy to deal with the disequilibrium situation.