TOPIC 03-QNTY THEORY OF MONEY;FISHERS APPROACH.pptx

finance presentation

1. TOPIC 3 QUANTITY THEORY OF MONEY; FISHERS APPROACH Monetary Theory and Practice Presentation by SK 1

2. Introduction Money is the life blood of the modern economies. We cannot think of an economy without money. Money is used as a medium of exchange and it is its most important function. What a unit of money buys, in terms of commodities and services represents its true value. But it is very difficult to measure the value of money, in terms of each and every commodity.

3. Introduction It is for this reason that the value of money is expressed-in terms of general price level' which may also be called as the purchasing power of money. Just as the price of a commodity, May increase or decrease, the may also move upward or downward. general price level The fluctuations in the general price level have a great impact on the, value of money. General Price level and the value of money are inversely related

4. Fishers quantity theory of Money 'If the price level goes up, it means the one unit of currency can now purchase less commodities and services i.e. the value of 'money Or the exchange value- of money has decreased. On the contrary the fall in general price level may increase the value of money. Thus, value of money means its purchasing power in terms of commodities and services.' ' Economists' have formulated a number of theories to explain the relationship between the- supply of' money and the general price level.

5. Fishers quantity theory of Money The Quantity Theory of money was first expounded by an-Italian economist Mr. Davanzatti but the theory was popularized by the American economist, Irving Fisher who gave it a quantitative form and explained it by an equation known as Equation of Exchange. At present, there are two versions; The transaction approach, (transaction approach is associated with Irving Fisher) The cash balance approach.(Cambridge version)

6. The Quantity Theory of Money – The Transaction Approach The value of money implies what a unit of money can buy in terms of' commodities and services. The price of commodities or the general price level does not remain constant hence the value of money 'also fluctuates . The two have inverse relationship. If general price level increases, the value of money decreases or the value of money 'increases with the decrease in general price level. The quantity theory of money indicates that the value of money in a given period depends upon the quantity of money in circulation in the economy.

7. The Quantity Theory of Money – The Transaction Approach The quantity' of money supply determines the general price level and the value of money. Any change in the money supply will change the general price level directly and the value of money inversely in the same ·proportion. e.g. if the quantity of money in circulation is doubled other things being equal, the general price level will be doubled and the' value of money is halved . Similarly, if the quantity of money is halved, the price level will be halved and the value of money will be doubled.

8. The Quantity Theory of Money – The Transaction Approach Prof. FW. Taussig has stated tendency of this theory thus- "Double the quantity of money, and other things being equal; prices will be twice as high as before; and the value of money as, 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." According to J.S. Mill,' "the value of money, other things being the same, varies inversely as its quantity ; increase of quantity lowers the value and every diminution raising it in a ratio, exactly equivalent”

9. Equation of Exchange MV=PT Where M = Quantity of money in circulation V = Velocity of circulation of money. It denotes average number of times a unit Of money changes hands. P = Price level T= Total volume of transactions of goods and s ervices during a' given period of time. The above equation has two sides i e. MV and PT.

10. Equation of Exchange MV=PT MV represents total supply of money in the economy M represents the total money supply in circulation but a unit of money does not purchase goods and services in a given period of time, only once . It changes hands by a number of times. Hence total money supply is represented by the quantity of money multiplied by its velocity which is represented by MV in the equation:

11. Equation of Exchange PT, on the other side of the equation represents total demand for money or the money value of all the goods and services bought during a given period of time. Hence total volume of transactions (T) multiplied by the price level (P) denotes the total demand of money. Thus MV=PT. or total supply of money (MV) is equal to total demand of money purchase the total' transactions at a given price (PT). The equation is referred to as the cash transaction equation. It could also be .expressed as follows- . 'P = MV T

12. Equation of Exchange Thus, price level is determined by the total quantity of money divided by the total transactions. Thus the total quantity of money determines the price level provided P and, T are constant. The above equation was criticized by some of the monetary experts on the ground that the theory ignores completely the credit money and its velocity both of which are important in the modern day economy.

13. Equation of Exchange Irving Fisher, later, extended his original equation, considering the credit money and its velocity represented by M' and V' respectively and put the extended equation as follows:- MV+M'V'=PT M’ = Quantity of credit money in circulation V’ = Velocity of credit money circulation of money. Other factors remain the same

14. Equation of Exchange The equation broadly indicates that the price level (P) is directly related to total quantity, of money (original money and bank money) multiplied by its velocity. It, is, however, inversely related to T. He has established in his equation the basic proposition that the price level and the value of money is a function of money supply "provided other things remain constant.’’

15. Equation of Exchange These other things are M'V’ V and T and if they remain constant, price level will change directly and proportionately with the change in money supply. Price level affects the value of money inversely and thus changes in money supply influences the value of money inversely. Example 1; The following data relates to economy ABC: M = 50 M’ = 20 T = 450, V = 10, V’ = 20 Compute the countries: (a) Price level (b) Value of money

16. Equation of Exchange

17. Equation of Exchange Example 2 If money supply in a given economy equals 1000 while the velocity and price equals 16 and 4 respectively. Determine the level of nominal and real output

18. Equation of Exchange

19. Assumptions of Fisher’s Equation Price level (or P) is a passive' factor. P in the equation (Price level) is inactive' or passive in the equation. T and V are constant. T and V are Independent Factors The Ratio of Credit Money to Legal Tender 'Money Remains Constant.

20. Criticism of the Quantity Theory of money – (Fisher’s equation of exchange) The theory is based upon; unreal assumptions. . According to Fisher P is a passive factor, T is independent,' M’V and V' are constant in the short period. Constant in the short period. He covered 'up all these assumption under 'other things remaining the .same’ 2. A Long-Term Analysis of Money. The theory offers a long term analysis of value of money and ignores the changes in short Period. 'However, there are certain violent- and far-reaching changes in the short run in the value of money which the theory ignores.

21. Criticism of the Quantity Theory of money – (Fisher’s equation of exchange) 3. How Money-supply influences the price level is not Explained. It throws: no' light on Cause and effect relationship of money and price. ‘ 4. No, Direct and Proportional Relationship between' Quantity of Money and the Price Level. in actual life, no such relationship exists because there are other external factors which disturb this relationship. 5.Assumption of Full Employment is wrong. Keynes has raised an objection is a rare phenomenon in an economy and the theory IS not real.

22. Criticism of the Quantity Theory of money – (Fisher’s equation of exchange) 6. The Theory is not comprehensive. A part of the total legal tender money is hoarded by the people which is not used for the' exchange of goods and services. So, the hoarded money should not be considered, 7. Money Supply is not the only factor influencing price level. 8. The Theory Neglects Velocity of Commodities. This is a serious drawback of the theory.

23. Criticism of the Quantity Theory of money – (Fisher’s equation of exchange) Other criticisms Demand aspect of money is not considered. The expression MV in the equation is not technically a consistent expression. It is not possible, according to critics, to measure the velocity of circulation of money. there, is time lag between the change in, money supply and its effect on price level. It is not instantaneous' and immediate. It is slow and gradual. It is possible that other things may not remain constant by that time. The theory does, not consider the changes in the price ,level of other countries which also affect the domestic price

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