QUANTITY THEORY OF MONEY

Quality theory of Money can be analysed by two different approaches:

(1) Fisher’s Theory

(2) Cash Balance Approach

Fisher’s Theory

• The theory explains the relationship between money supply and price level.

• Irving Fisher used an equation [MV = PT]

• M stands for total Money Supply.

• V means velocity of circulation money which implies the average number of times that a unit of money changes hands during a particular period.

• P is Price level i.e. average price of GNP.

• T is Total National output.

• Fisher used the equation to show the relationship between money supply and price level as direct and proportional.

• The rate of change in money supply (dM/M) is equal to rate of change in P (dP/P).

• Graphically the curve showing the relation between M and P will be a 45 degree line passing through the origin.

Fisher’s theory is based upon three assumptions:

The relation between M and P will be proportional only when there are no changes in the value of V and T i.e. V and T are constant variables.

(a) Velocity of circulation of money depends on the spending habit of people. Spending habit of people is, more or less, stable. Hence V will be constant normally.

(b) T or GNP will be constant in situation of full employment when all the available factors of production are fully employed. At less than full employment, more money will lead to more output by utilizing unused factor. Hence P will not rise.

(c) Fisher’s theory assumes that money is demanded for the transaction purposes only. People spend their entire income instantly for transaction.

Criticisms

(a) Fisher’s equation is abstract and mathematical truism. It does not explain the process by which M affects P.

(b) It is presumed that entire M is used up in buying T instantly. It is unreal. No one spends all money the moment he earns it. Keynes pointed out that money is demanded for transaction purposes, precautionary purpose and also speculative purpose. Fisher does not explain the last two roles of money.

(c) The concept full employment is myth. There is natural rate of unemployment in every country.

(d) Even with full employment, a country can rise national output by bringing those factors which are not available within economy from abroad.

(e) It is presumed that money is used for transactions only. Hence the theory is often referred to as Cash Transaction Theory. This ignores the other roles of money.