Fisher’s transactions approach
Quantity Theory of Money: Fisher’s Transactions Approach:
The general level of prices is determined, that is why at sometimes the general level of prices rises and sometimes it declines. Sometimes back it was believed by the economists that the quantity of money in the economy is the prime cause of fluctuations in the price level.
The theory that increases in the quantity of money leads to the rise in the general price was effectively put forward by Irving Fisher. They believed that the greater the quantity of money, the higher the level of prices and vice versa.
Therefore, the theory which linked prices with the quantity of money came to be known as quantity theory of money. In the following analysis we shall first critically examine the quantity theroy of money and then explain the modern view about the relationship between money and prices and also the determination of general level of prices.
The quantity theory of money seeks to explain the value of money in terms of changes in its quantity. Stated in its simplest form, the quantity theory of money says that the level of prices varies directly with quantity of money. “Double the quantity of money and other things being equal, prices will be twice as high as before and the value of money one-half. Halve the quantity of money and other things being equal, prices will be one-half of what they were before and the value of money double.”
The theory can also be stated in these words: The price level rises proportionately with a given increase in the quantity of money. Conversely, the price level falls proportionately with a given decrease in the quantity of money, other things remaining the same.
There are several forces that determine the value of money and the general price level.
The general prices level in a community is influenced by the following factors:
(a) The volume of trade or transactions,
(b) Th quantity of money:
(c) Velocity of circulation of money.
The first factor, the volume of trade or transactions, depends upon the supply or amount of goods and services to be exchanged. The greater the amount or supply of goods in an economy, the larger the number of transactions and trade and vice versa.
But the classical and neoclassical economists who believed in the quantity theory of money assumed that Jull employment of all resources (including labour) prevailed in the economy. Resources being fully employed the total output or supply of goods (and therefore the total or transactions) cannot increase. Therefore, those who believed in the quantity theory of money assumed that the total volume of trade or transactions remained the same.
The second factor in the determination of general level of prices is the quantity of money. It should be noted that the quantity of money in the economy consists of the not only the notes and currency issued by the Government but also the amount of credit or deposits created by the banks. The third factor influencing the price level is the velocity of circulation. A unit of money is used for exchange and transactions purposes not once but several times in a year. During several exchange of goods and services, a unit of money passes from one hand to another.
Hence, the velocity of money is the number of times a unit of money changes hands during exchanges in a year. The work done by one rupee, which is circulated five items in a year is equal to that done by the five rupees which change hands only once each.
Let us illustrate the quantity theory of money. Suppose in a country there is only one good, wheat, which is to be exchanged. The total output of wheat is 2,000 quintals in a year. Further suppose that the government has issued money equal to Rs. 25,000 and no credit is issued by the banks. We further assume that one rupee is used four times in a year for exchange of wheat.
That is, velocity of circulation of money is four. Under these circumstances, 2,000 quintals of wheat are to be exchanged for Rs. 1,00,000 (25,000-4-1,00,000). The price of wheat will be 1,00,000/2,000= Rs 50 per quintal. Suppose the quantity of money is doubled to Rs. 50,000. While the output of wheat remains at 2,000 quintals. As a result of this increase in the quantity of money, the price of wheat will rise to 2,00,000/2,000 Rs. 100 per quintal.
Thus with doubling of the quantity of money, the price has doubled. If the quantity of money if further increased to Rs. 75,000, the amount of wheat remaining constant, the price level will rise to 3,00,000/2,000 Rs. 150 per quintal. It is thus clear that if the volume of transactions, i.e., output to be exchanged remains constant the price level rises with the increase in the quantity of money.
Fisher’s Equation of Exchange: An American economist, Irving Fisher, expressed the relationship between the quantity of money and the price level in the form of an equation, which is called ‘the equation of exchange.
This is:
PT MV…(1) Or P-MV/T
Where P stands for the average price level: T stands for total amount of transactions (or total trade or amount of goods and services, raw materials, goods etc.) M stands for the quantity of money; and V stands for the transactions velocity of circulation of money.
The equation (1) or (2) is an accounting identity and true by definition This is, because MV which represents money spent on transactions must be equal to Pr which represents money received from transaction. However, the equation of exchange as given in equations (1) and (2) has been converted into a theory of determination of general level prices by the classical economists by making some assumptions. First, it has been assumed that mystical volume of transactions is constant because it is determined by a given amount of real resources, the given level of technology and the efficiency with which the given available resources are used. These real factors determine a level of aggregate output which necessitates various types of transactions. Another crucial assumption is that transactions. velocity of circulation (V) is also constant. The quantity theorists accordingly believed that velocity of circulation (V) depends on the methods. and practices of factor payments such as frequency of wage payments to the workers and habits of the people regarding spending their money incomes after they receive them.
Further, velocity of circulation of money also depends on the development of banking and credit system, that is, the ways and speed with which cheques are cleared, loans are granted and repaid. According to them, these practices do not change in the short run.
This assumption is very crucial for the quantity theory of money because when the quantity of money is increased this may cause a decline in velocity of circulation of money, then MV may not change if the decline in V offsets the increase in M. As a result, increase in M will not affect PY The quantity theorists believed that the volume of transactions (T) and the changes in it were largely independent of the quantity of money. Further, according to them, changes in velocity of circulation (VO and price level (P).
do not cause any change in volume of transactions except temporarily. Thus classical economists who put forward the quantity theory of money believed that the number of transactions (which ultimately depends on aggregate real output) does not depend on other variables (M, V and P) in the equation of exchange. Thus we see that the assumption of constant V and T converts the equation of exchange (MV PT), which is an accounting identity, into a theory of the determination of general price level.
The quantity of money is fixed by the Government and the Central Bank of a country. Further, it is assumed that quantity of money in the economy depends upon the monetary system and policy of the central bank and the Government and is assumed to be autonomous of the real forces which determine the volume of transactions or national output.
Now, with the assumptions that M and V remain constant, the price level P depends upon the quantity of money M; the greater the quantity of M, the higher the level of prices. Let us give a numerical example. Suppose the quantity of money is Rs. 5,00,000 in an economy, the velocity of circulation of money (V) is 5; and the total output to be transacted (T) is 2,50,000 units, the average price level (P) will be:
P=MV/T
-5,00,000×5/2,50,000-2,50,000/2,50,000 = Rs. 10 per unit.
If now, other things remaining the same, the quantity of money is doubled, i.e., increased to Rs. 10,00,000 then:
P=10,00,000 x 5/2,50,000 Rs. 20 per unit We thus see that according to the quantity theory of money, price level varies in direct proportion to the quantity of money. A doubling of the quantity of money (M) will lead to the doubling of the price level. Further, since changes in the quantity of money are assumed to be independent or autonomous of the price level, the changes in the quantity of money become the cause of the changes in the price level.
Quantity Theory of Money: Income Version: Fisher’s transactions approach to quantity theory of money described in equation (1) and (2) above considers such variables as total volume of transaction (T) and avaerage price level of these transactions are conceptually vague and difficult to measure.
Therefore, in later years quantity theory was formulated in income from which considers real income or national output (i.e., transactions of final goods only rather than all transactions. As the data regarding national income or output is readily available, the income version of the quantity theory is being increasingly used. Moreover, the average price level of output is a more meaningful and useful concept.
Indeed, in actual practice, the general price level in a country is measured taking into account only the prices of final goods and services which constitute national product. It may be noted that even in this income version of the quantity theory of money, the function of money is considered to be a means of exchange as in the transactions approach of Fisher.
In this approach, the concept of income velocity of money has been used instead of transactions velocity of circulation. By income velocity we mean the average number of times per period a unit of money is used in making payments involving final goods and services, that is, national product or national income. In fact, income velocity of money is measured
by Y/M where Y stands for real national income nad M for the quantity of money
In view of the written as under:
MV-PY…(3)
above, the income version of quantity theory of money is
P=MV/PY…(4)
Where
M-Quantity of money.
V=Income velocity of money P-Average price level of final goods and services
Y-Real national income (or aggregate output)
Like that in the transactions approach, in this new income version of the quantity theory also the different viables are assumed to be independent of each other. Further, income velocity of money (V) and real income aggregate output (Y) is assumed to be given and constant during a short period.
More specifically, they do not vary in response to the changes in M. In fact, real income or output (Y) is assumed to be determined by the real sector forces such as capital stock, the amount and skills of labour. technology etc. But as these factor are taken to be given and constant in the short ran and further full employment of the given resources is assumed to be prevailing due to operation of Say’s law and wage-price flexibility supply of output is taken to be inelastic and constant for purposes of determination of price level.
It follows from equations (3) and (4) above that with income velocity (V) and national output (F) remaining constant, price level (P) is determined by the quantity of money (M).
Classical quantity theory of money is illustrated in Fig. 4 through aggregate demand and aggregate supply model. It is worth noting that the quantity of money (A/) multiplied by the income velocity of circulation (V). that is, MV gives us aggregate expenditure in the quantity theory of money. Now with a given quantity of money, say M, and constant velocity of money V, we have a given amount of monetary expenditure (M, V).
Given this aggregate expenditure expenditure, at a lower price level more quantities of goods can be purchased and at a higher price level, less quantities of goods can be purchased. Therefore, in accordance with classical quantity theory of money aggregate demand representing M, slopes downward as shown by the aggreagte demand curve AD, in Fig. 4. If now the quantity of money is increased, say to M,, aggregate demand curve representing new aggregate monetary expenditure M, V will shift upward.
As regard, aggregate supply curve, due to the assumption of wage price flexibility, it is perfectly inelastic at full-employment level of output as is shown by the vertical aggregate supply AS in Fig. 20.1. Now, with a given quantity of money equal to M,, aggregate demand curve AD, cuts the aggregate supply curve AS at point E and determines price level OP,
Now, if the quantity of money is increased to M,, the aggregate demand curve shifts upward to AD,. It will be seen from Fig. 4 that with the increase in aggregate demand to AD, consequent to the expansion in money supply to M., excess demand equal to EB emerges at the current price level OP₁. This excess demand for goods and services will lead to the rise in price level to OP, at which again aggregate quantity demanded equals the aggregate supply which remains unchanged at OY due to the existence of full employment in the economy.
Keyne’s Critique of the Quantity Theory of Money: The quantity theory of money has been widely criticised.
The following criticisms have been levelled against the quantity theory of money lay by Keynes and his followers: 1. Useless truism: With the qualification that velocity of money (V)
and the total output (T) remain the same, the equation of exchange (MV-PT) is a useless truism. The real trouble is that these things seldom remain the same. They change not only in the long run but also in a short period. Fisher’s equation of exchange simply tells us that expenditure made on goods (MV) is equal to the value of output of goods and services sold (PT).
2. Velocity of money is not stable:
Keynesian economists have challenged the assumption that velocity of money remains stable. According to them, velocity of money changes inversily with the change in money supply. They argue that increase in money supply, demand for money remaining constant, leads to the fall in the rate of interest.
Ata rate of interest, people will be induced to hold more money as idle cash balances (under speculative motive). This means velocity of circulation of money will be reduced. Thus, if a decline in interest rate reduces velocity, then increase in the money supply will be offset by reduction in velocity, with the result that price level, need not rise when money supply is increased.
3. Increase in quantity of money may not always lead to the increase in aggregate spending or demand: Further, according to Keynes’ the quantity theory of money is based upon two more wrong assumptions
