Fishers Quantity Theory of Money

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 exactly
proportionate change in the price level.
In the words of Irving 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. 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 the quantity of
money is reduced by one half, the price level will also be reduced by one half and the value
of money will be twice.
Fisher has explained his theory in terms of his equation of exchange:
PT=MV+ M V
Where P = price level, or 1 IP = the value of money;
M = the total quantity of legal tender money;
V = the velocity of circulation of M;
M the total quantity of credit money;
V = the velocity of circulation of M;
T = the total amount of goods and services exchanged for money or transactions performed
by money.
This equation equates the demand for money (PT) to supply of money (MV=MV). The total
volume of transactions multiplied by the price level (PT) represents the demand for money.
According to Fisher, PT is SPQ. In other words, price level (P) multiplied by quantity bought
(Q) by the community (S) 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 V plus the total quantity of credit money M and its velocity of circulation V.
Thus the total value of purchases (PT) in a year is measured by MV+MV. Thus the equation
of exchange is PT=MV+MV. 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
P= MV+MV/T
Fisher points out the price level (P) (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 doubled, while V, V
and T remain constant, P is also doubled, but the value of money (1/P) is reduced to half.
Fishers quantity theory of money is explained with the help of Figure 1. (A) and (B). Panel
A of the figure shows the effect of changes in the quantity of money on the price level. To
begin with, when the quantity of money is M, the price level is P.
When the quantity of money is doubled to M2, the price level is also doubled to P2. Further,
when the quantity of money is increased four-fold to M4, the price level also increases by
four times to P4. This relationship is expressed by the curve P = f (M) from the origin at 45.
In panel of the figure, the inverse relation between the quantity of money and the value of
money is depicted where the value of money is taken on the vertical axis. When the quantity
of money is M1 the value of money is HP. But with the doubling of the quantity of money to
M2, the value of money becomes one-half of what it was before, 1/P2. And with the quantity
of money increasing by four-fold to M4, the value of money is reduced by 1/P4. This inverse
relationship between the quantity of money and the value of money is shown by downward
sloping curve 1/P = f (M).

Assumptions of the Theory:

Fishers theory is based on the following assumptions:
1. P is passive factor in the equation of exchange which is affected by the other factors.
2. The proportion of M to M remains constant.
3. V and V are assumed to be constant and are independent of changes in M and M.
4. T also remains constant and is independent of other factors such as M, M, V and V.
5. It is assumed that the demand for money is proportional to the value of transactions.
6. The supply of money is assumed as an exogenously determined constant.
7. The theory is applicable in the long run.
8. It is based on the assumption of the existence of full employment in the economy.
Criticisms of the Theory:
The Fisherian quantity theory has been subjected to severe criticisms by economists.
1. Truism:
According to Keynes, The quantity theory of money is a truism. Fishers equation of
exchange is a simple truism because it states that the total quantity of money (MV+MV)
paid for goods and services must equal their value (PT). But it cannot be accepted today that
a certain percentage change in the quantity of money leads to the same percentage change in
the price level.
2. Other things not equal:
The direct and proportionate relation between quantity of money and price level in Fishers
equation is based on the assumption that other things remain unchanged. But in real life, V,
V and T are not constant. Moreover, they are not independent of M, M and P. Rather, all
elements in Fishers equation are interrelated and interdependent. For instance, a change in M
may cause a change in V.
3. Constants Relate to Different Time:
Prof. Halm criticises Fisher for multiplying M and V because M relates to a point of time and
V to a period of time. The former is a static concept and the latter a dynamic. It is therefore,
technically inconsistent to multiply two non-comparable factors.
4. Fails to Measure Value of Money:
Fishers equation does not measure the purchasing power of money but only cash
transactions, that is, the volume of business transactions of all kinds or what Fisher calls the
volume of trade in the community during a year. But the purchasing power 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.
5. Weak Theory:
According to Crowther, the quantity theory is weak in many respects. First, it cannot explain
why there are fluctuations in the price level in the short run. Second, it gives undue
importance to the price level as if changes in prices were 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.

Meaning and Effects of Deflation

Deflation is a state in which the value of money is rising i.e. prices are falling. It is usually
associated with falling activity and employment. As pointed out by Coulborn, Involuntary
unemployment is the hall-mark of deflation. Deflation is caused when prices are falling
more than proportionately to the output of goods and services in the economy as a result of
decrease in the money supply.
Sometimes, deflation is confused with disinflation. Deflation is a situation when prices fall
along with reduction in output and employment. Disinflation, on the other hand, is a situation
when prices are reduced deliberately but output and employment remain unaffected.
According to Coulborn, A lowering of prices, income, and expenditures, when they would
be beneficial, would be disinflation.
Deflation affects all aspects (i.e., economic, social and political) of the life of the country.
Various effects of deflation are discussed below:

(A) Effects on Different Sections of Society

Deflation influences different sections of the society in the following manner:
1. Production:
Deflation adversely affects the producers:
(a) During deflation, production costs do not fall as rapidly as the prices of finished goods,
(b) When the producer buys raw material and other inputs, he pays a higher price, but by the
time he reached the market to sell his finished products, the prices of raw materials will fall
because of deflation. Thus the producer will be forced to sell his products at a lower price;
(c) The demand for commodities goes on falling: due deflation. As a result of this the profits
of the producer will fall and there will be overproduction of the commodities. Similarly,
deflation also adversely affects the farmers, particularly the small farmers.
2. Distribution
Deflation affects adversely the distribution of income and wealth. When prices are falling, the
purchasing power is increasing. So the lower, middle, and other classes with low incomes
gain. On the other hand, businessmen, industrialists, traders, real estate holders, and others
with variable incomes are hit hard and their profits decline with deflation.
But this does not mean that there is improvement in income distribution. Rather, the low
income groups suffer more because of the fall in employment and income. So both the better
off and the worse off feel discontented under deflation.
3. Traders:
The traders are also adversely, affected during deflation. When they make purchases, they
have to pay higher prices, but when they sell the products prices fall due to deflationary trend.
As a result, the traders are likely to lose.
4. Investors:
Different types of investors are affected differently due to deflation:
(a) The fixed-income investors (like debenture and bond holders) gain by deflation because
incomes remain constant while the prices fall.
(b) The variable income investors (like equity holders) will lose during depression, because
their incomes fall with the falling prices.
5. Salaried and Labour Classes:
Wage earners and salaried persons gain during deflation. The reason is that with the fall in
prices, the wages and salaries cannot be reduced; such attempts will be strongly opposed by
the trade unions.
6. Consumers:
The consumers generally gain due to falling prices because the purchasing power of their
money rises. Consumers are of two types: (a) The consumers whose income remains fixed
(i.e, salaried persons) will be benefited by deflation. (b) The consumers whose income falls
during deflation (e.g., profit earners) may lose during deflation.
7. Creditors and Debtors:
During deflation, the prices fall and the value of money rises. As a result, the creditors tend to
gain and the debtors tend to lose.

(B) Other Effects on the Economy

Deflation also affects the general life of the economy in the following way:
(i) Tax-payers are adversely affected in the deflationary period because due to falling prices,
the value of money rises and the real burden of taxation increases.
(ii) The government faces an increase in the rea 1 burden of public debt.
(iii) Due to falling prices and profits, the entrepreneurs reduce output. Some small businesses
may close down. This results in the unemployment of workers and employees.
(iv) Banking business also suffers during deflation because the number of borrowers falls
sharply due to general recession in the economy.
(v) Like the private sector units, the public sector enterprises also suffer losses during
deflation when the prices fall.
(vi) Deflationary conditions lead to greater number of industrial disputes and thus create
industrial unrest in the economy.
(vii) During deflation, the pace of economic growth slows down or even suffers a setback and
the economic, social and political life of the country get disturbed.
In short, deflation is even worse than inflation. Middle class people gain at the expense of the
richer classes. Reduction in output and wide-spread unemployment adversely affect the
economic life of the country and lead to social unrest.

Says Law
Says Law states that supply always creates its own demand. In other words, according to
J.B. Say, there cannot be general overproduction or general unemployment on account of the
excess of supply over demand because whatever is supplied or produced is automatically
exchanged for money.
In an exchange economy whatever is produced represents the demand for another product
because whatever is produced is meant to be sold. Whenever additional production takes
place in the economy, necessary purchasing power is also generated at the same time to
absorb the additional supply; hence, there is no scope of supply exceeding demand and
causing unemployment. This law was the basis of their assumption of full employment in the
economy.
The proposition rested on the plea that income is spent automatically at a rate which will
always keep the resources fully employed. Savings according to classical are just another
form of spending; all income, they believed, is in a large part spent on consumption and the
rest on investment. There is no ground to fear a diminution in the flow of income stream in
the economy. Hence, there cannot be any general over-production or unemployment.
J.B. Says thinking became quite popular with the English economists. As the elementary
principle of an exchange economy based on simple organisation of industry, it was quite an
acceptable idea. As it was handed down, it came to be briefly stated as that supply creates
its own demand. It meant that there cannot be any general over-production or general
unemployment in the economy as whatever is produced is automatically consumed.
It implied that every producer who brings goods to the market does so only to exchange them
for other goods. Say believed that people did not work for its own sake but to obtain other
goods and services that would satisfy their wants. To be employed simply meant to work in a
field or to start a shop and to sell ones own product in the market. The organisation of the
economy was simple under which people spent on tools and consumer goods. Saving and
investment were not separate processes.

Assumptions:
The statement of Says Law is based, more or less, on the following assumptions:
(i) That the free enterprise system based on price mechanism provides a place for growing
population and an increase in capital automatically.
(ii) In an expanding economy new firms and workers find their way into the productive
process, not by displacing others but by offering their own products in exchange.
(iii) The extent of the market is not limited and incapable of expansion. The extent of the
market is as big as the volume of products offered in exchange.
(iv) There is no necessity on the part of government to intervene in business matters so that
the attainment of automatic adjustment is facilitated.
(v) Flexibility of interest rates and the long period were considered essential for its successful
working.
Says Law of Markets was put by the classical economists in a different form, a proposition
denying the possibility of large scale involuntary unemployment for a long period of time.
According to Prof. Pigou, there cannot be any general unemployment in the labour market if
the labour is just prepared to accept a wage according to its marginal productivity.
In a free enterprise economy where there is free, perfect and thorough going competition, if
the labourers just accept low enough wages, unemployment would vanish completely (except
seasonal and frictional unemployment). Such conditions did prevail, according to Prof. Pigou,
before the First World War and as a result there did not exist unemployment except in a
temporary form.
After the War, however, circumstances had changed and certain new forces had arisen to
weaken the competitive forces in the labour market. For example, minimum wage laws,
collective bargaining, growth of trade unions, unemployment insurance, arrangements
between workers and employers, group pressures and government intervention. These factors
had gone a long way to make the labour markets imperfect and hence the chances of
unemployment had multiplied. Therefore, reduction in wage rates could not take place.

Professor Pigou gave a new defence of the Says Law of Markets with his argument of
increasing employment through wage flexibility. He suggested that when there is economy-
wide unemployment and real wages are allowed to be cut via labour-market competition that
reduces costs of production and prices. When the general price level goes down, the value of
the wealth held by the general public increases which encourages greater consumption on the
part of the wealth holders.

This argument of Pigou is popularly called the Pigou Effect. This increases the effective
demand in the economy to the level where there is full employment. Thus, in Pigous view, if
there is wage and price flexibility, then aggregate demand and aggregate supply get equated
only at the level of full employment.
This conclusion, of course, implies the application of the quantity theory of money. The
condition which the economy satisfies at full employment is Aggregate demand SP 1D1 =
SP1S1 = Aggregate Supply. This means that total expenditure is equal to total supply of
output at the full employment level. In other words, that circular flow of income (Y) and
expenditure (C +1) is maintained.

The main points of criticism of Says Law of Markets are as follows:

1. Possibility of Deficiency of Effective Demand
2. Prolonged Depressions a reality
3. Fallacy of Aggregation
4. Misplaced Confidence in the Efficacy of Wage Cuts
5. Wrong Assumption of Interest-elasticity of Investment
6. Presence of Monopoly Element in Product and Factor Markets
7. Importance of Short-run Economics

Classical Theory of Employment

The classical economists believed in the existence of full employment in the economy. To
them, full employment was a normal situation and any deviation from this regarded as
something abnormal. According to Pigou, the tendency of the economic system is to
automatically provide full employment in the labour market when the demand and supply of
labour are equal. Unemployment results from the rigidity in the wage structure and
interference in the working of free market system in the form of trade union legislation,
minimum wage legislation etc. Full employment exists when everybody who at the running
rate of wages wishes to be employed.
Those who are not prepared to work at the existing wage rate are not unemployed because
they are voluntarily unemployed. Thus full employment is a situation where there is no
possibility of involuntary unemployment in the sense that people are prepared to work at the
current wage rate but they do not find work.
The basis of the classical theory is Says Law of Markets which was carried forward by
classical economists like Marshall and Pigou. They explained the determination of output and
employment divided into individual markets for labour, goods and money. Each market
involves a built-in equilibrium mechanism to ensure full employment in the economy.

Determination of Output and Employment in Classical Theories

In the classical theory output and employment are determined by the production function and
the demand for labour and the supply of labour in the economy. Given the capital stock,
technical knowledge and other factors, a precise relation exists between total output and
amount of employment, i.e. number of workers. This is shown in the form of the following
production function. Q = f (K,T,N)
Where, total output Q is a function (f) of capital stock (K), technical knowledge (T) and the
number of workers (N).
Given K and T, the production function becomes Q = f (N) which shows that output is a
function of the number of workers, output increases as the employment of labour arises.
But after a point when more workers are employed, diminishing marginal returns to labour
start, where the curve Q = f (N) is the production function and the total output OQ1
corresponds to the full employment level NF. But when more workers N1, N2 are employed
beyond the full employment level of output OQ1, the increase in output Q1Q2 is less than the
increase in employment N1N2. It is represented in the above diagram.
Its Assumptions:
The classical theory of output and employment is based on the following assumptions:
1. There is the existence of full employment without inflation.
2. There is a laissez-faire capitalist economy without government interference.
3. It is a closed economy without foreign trade.
4. There is perfect competition in labour and product markets.
5. Labour is homogeneous.
6. Total output of the economy is divided between consumption and investment expenditures.
7. The quantity of money is given and money is only the medium of exchange.
8. Wages and prices are perfectly flexible.
9. There is perfect information on the part of all market participants.
10. Money wages and real wages are directly related and proportional.
11. Savings are automatically invested and equality between the two is brought about by the
rate of interest
12. Capital stock and technical knowledge are given.
13. The law of diminishing returns operates in production.
14. It assumes long run.
Criticism of Classical Theory:
Keynes vehemently criticised the classical theory of employment for its unrealistic
assumptions in his General Theory.
He attacked the classical theory on the following counts:
(1) Underemployment Equilibrium:
Keynes rejected the fundamental classical assumption of full employment equilibrium in the
economy. He considered it as unrealistic. He regarded full employment as a special situation.
The general situation in a capitalist economy is one of underemployment.
(2) Refutation of Says Law:
Keynes refuted Says Law of markets that supply always created its own demand. He
maintained that all income earned by the factor owners would not be spent in buying products
which they helped to produce.
(3) Equality of Saving and Investment through Income Changes:
The classicists believed that saving and investment were equal at the full employment level
and in case of any divergence the equality was brought about by the mechanism of rate of
interest. Keynes held that the level of saving depended upon the level of income and not on
the rate of interest.
(4) Importance of Speculative Demand for Money:
The classical economists believed that money was demanded for transactions and
precautionary purposes. They did not recognise the speculative demand for money because
money held for speculative purposes related to idle balances.
(6) Rejection of Quantity Theory of Money:
Keynes rejected the classical Quantity Theory of Money on the ground that increase in
money supply will not necessarily lead to rise in prices. It is not essential that people may
spend all extra money. They may deposit it in the bank or save.
(7) Money not Neutral:
The classical economists regarded money as neutral. Therefore, they excluded the theory of
output, employment and interest rate from monetary theory. According to them, the level of
output and employment and the equilibrium rate of interest were determined by real forces.

Credit Creation Process

We know that a bank accepts money from public as deposits. Normally these deposits are
supposed to be returned back to the public if they want to withdraw them. So if all the
persons, who have deposited money in the bank, withdraw their total money, then bank will
be left with no money at all. But such things normally do not happen. Mostly, people
withdraw a smaller amount from their deposit whenever they require and leave the rest of the
amount with the bank. The bank always keeps some fraction of its total deposits in the form
of cash from which it keeps giving money to people who come to withdraw it. We call the
fraction of the total deposit to be kept in the form of cash as cash reserve ratio. Once the
bank calculates the amount to be kept as cash on the basis of cash reserve ratio, it deducts the
amount from the total deposits and uses the rest of the amount to give loans to the borrowers.
With this act of the bank, the process of credit creation starts from here.
Steps in Credit Creation
To make things simple, let us think that there is only one bank in the economy.
Let the banking authority has decided that the cash reserve ratio is 20 percent. So,
the bank must keep 20 percent of its current deposit in the form of cash to make
cash payments to persons who come to withdraw money.
Step1. A person called A, deposits Rs.100 in the bank. As a result the banks deposits
increases by Rs.100. As per rule the bank keeps 20% of 100 as cash. This comes out to be
Rs.20. So the bank keeps Rs.20 to make cash payments. Now deduct 20 from 100. 100 20 =
80. So the bank can use Rs.80 to give loan.
Step 2. A person called B approaches the bank to take a loan of Rs.80. After the bank gives
this loan, it can claim the amount from B in future. This means that by giving loan to person
B, the bank can create another deposit Rs.80. Now calculate the total deposit with the bank
First, person A deposited Rs.100. By giving loan to B, the bank is able to claim Rs.80. So
after two steps the bank has total deposit of Rs.180. i.e 100 + 80 = 180
Step 3. Another person called C wants a loan from the bank. How much amount of money
the bank can give as loan to C? In the previous step we saw that, the bank could increase its
deposit by Rs.80 by claiming the amount from B. As per rule it has to keep 20% of 80 as cash
before giving further loan to anybody. 20% of 80 = 16. So the bank will now keep Rs.16 as
cash and give the rest of the amount as loan. 80 16 = 64. So the bank can give Rs.64 as loan
to C. Again by claiming this amount from C, the bank can create another deposit of Rs.64 in
step 3. Continuing from the previous two steps, we can say that, after three steps the total
deposits with the bank has increased upto 180 + 64 = 244. Or 100 + 80 + 64 = 244.

This chain will continue for some time. But when it will come to an end? You know
that in each round the bank keeps 20% of the increase in the deposit as cash. You
also know that the bank started with an increase in its deposit by Rs.100 in step
1. So the process of credit creation (or increase in deposits) will come to an end
when 20% of the deposits of each and every round taken together become 100 itself.
Now, Total Credit = Initial Increase in Deposit 1/Cash Reserve Ratio.
500 = 100 1/20%
Also remember another important point. Since the bank deposit is divided into 20% as cash
and the rest as loan through various steps, the total deposit of Rs.500 can be divided in the
following manner Cash Reserve = 20% 0f 500 = Rs.100 Loan Amount = 500 100 = Rs.400.