Understanding the Quantity Theory of Money: Fisher's Approach Explained
Overview
In this video, Vidhi Gavra breaks down the Quantity Theory of Money, focusing on Fisher's equation, its assumptions, and criticisms. The theory illustrates the relationship between money supply, price levels, and the value of money, providing a concise overview of its implications in economics.
Key Points
- Background: The theory dates back to the 16th century, observing that increased money flow from America to Europe led to rising prices. Ivan Fisher formalized this in 1911, linking money supply to inflation. For a deeper understanding of how inflation is influenced by various factors, check out our summary on Understanding Monetary Policy: Objectives and Instruments Explained.
- Fisher's Equation: The equation MV = PT represents:
- M: Money supply
- V: Velocity of money (how often money changes hands)
- P: Average price level
- T: Volume of transactions
- Assumptions:
- Velocity (V) and volume of transactions (T) remain constant.
- The economy operates at full employment.
- Prices are passive and change only due to other factors.
- Money is considered solely as a medium of exchange.
- Graphical Representation: The relationship between money supply and price is direct, while the relationship between price and the value of money is inverse. To explore how these concepts fit into broader economic models, see our summary on Understanding the Circular Flow Model in Economics.
- Criticisms:
- The assumption of constant V and T is challenged.
- Full employment is rarely achieved.
- Interest rates are overlooked.
- The theory emphasizes money as a medium of exchange, neglecting other functions of money. For insights into employment theories that may relate to these criticisms, refer to Understanding Classical Theory of Employment in Economics.
Conclusion
The Quantity Theory of Money provides a foundational understanding of how money supply impacts inflation and the value of money, though it faces significant criticisms regarding its assumptions and applicability in real-world scenarios. To further explore the historical context and foundational theories in economics, consider reading Classical Economics Insights: Adam Smith's Labor Division, Value Theory, and Ricardo's Distribution Views.
FAQs
-
What is the Quantity Theory of Money?
The Quantity Theory of Money explains the relationship between money supply and price levels in an economy, primarily through Fisher's equation MV = PT. -
Who developed the Quantity Theory of Money?
Ivan Fisher is credited with formalizing the theory in his 1911 work, "The Purchasing Power of Money." -
What does Fisher's equation represent?
Fisher's equation (MV = PT) represents the relationship between money supply (M), velocity of money (V), price level (P), and volume of transactions (T). -
What are the main assumptions of the theory?
The main assumptions include constant velocity and transaction volume, full employment, and that money is only a medium of exchange. -
What are some criticisms of the Quantity Theory of Money?
Criticisms include the unrealistic assumptions of constant V and T, neglect of interest rates, and the limited view of money's functions. -
How does the theory relate to inflation?
The theory posits that an increase in money supply leads to higher prices, thus contributing to inflation. -
Is the Quantity Theory of Money applicable in the real world?
While it provides a foundational understanding, its assumptions often do not hold true in dynamic economies, leading to criticisms.
[Music] hey guys my name is vidhi gavra and welcome back to my channel five minute
economics where i teach economic concepts in a span of just five minutes the topic for today is the
quantity theory of money fishers approach and in this particular video i'll be
covering the fish's equation the assumptions diagrams the background as well as the
criticisms in short all you need to know about this oh so simple theory so yeah let's get started also guys
please don't forget to subscribe to my channel in case you haven't already it will mean
a lot to me thank you so guys before we begin let me give you a little background of this theory
so this theory dates back to 16th century where it was observed then that when money was
flowing from america to europe the prices in europe started to increase because the money supply and lot of
increase so it dates back to that time whereas this theory was brought up by ivan fisher in the year 1911
where he spoke about it in his book but chasing power of money what did iron fishes observed he said
this as the quantity of money in an economy increases
the price aka the inflation tends to rise case member iring fisher is a monetarist
economist and he has brought out this concept very strongly where he said that one
important factor which is responsible for inflation is the rise in the money supply in the
economy he also said that at that time the value of money starts to
fall when the money supply increases through these two uh you know statements we can say that
there is a direct relationship between money supply and price as money supply increases
price also increases whereas there is an indirect relationship between money supply and value of money
the value of money keeps falling so initially a good maybe we can say a bunch of bananas which were available
for 10 rupees is now costing us 20 rupees so when the price rises you know the
value has fallen the value of money has fallen so this these two things were said
and he also said this is uh observed in citrus paribus that is other things remaining constant so guys
this is the equation mv is equal to pt which we will be studying further in detail but before
that let me just quickly run through the assumptions of the theory so number one velocity which is v over
here remains constant number two volume of transactions remain constant which is t
over here economy is at full employment it means everyone is fully employed next price is a passive factor it means
that price cannot change automatically it can change due to changes in some other factors like
change in money supply next this is a long run theory and lastly which is the most important
assumption is that money is used only as a medium of exchange that is we you know
know the functions of money store of value and all of that have been overlooked money is only looked as a
medium of exchange that is we've seen only the transaction demand of money
so now guys please pay attention because now we'll be doing the crux of this theory so whenever guys we study the
quantity theory of money fishers approach this particular equation mv is equal to
p is sub pt is something what you need to remember always so what does each variable over
here stand for so m stands for money supply chain money you know money in circulation
is our money supply whereas v is a velocity of money so what is basically velocity of money
velocity of money is basically the number of times money exchanges hands in an economy for example a
hundred rupee note so 100 rupee note we give it to someone then they go and buy something they give
it to someone and then they further go and you know buy that from that 100 rupee
note so number of times that 100 rupee note goes in circulation that frequency is known as velocity of money
p stands for the average price level pertaining in the economy whereas t stands for the volume of transactions
which occur in an economy so what does fisher say from his equation he says now let us just
consider the left hand side first which is the supply side so he says when we multiply
m into we that is the total money supply that is money supplied into our velocity of money okay number
of times that money supply has moved so we get the total money supply in an economy for example here we've
considered m as 100 and v velocity as 4 we get 400 as our mv whereas coming to the right
hand side of the equation which is pt what over here we say is that p stands for price revenue
right and t stands for volume of transactions so when the price is multiplied by the volume of
transactions we get pt so we get basically what the total money demanded for transaction
purposes for example we buy a phone cover we've kept the price as 200
and it's bought twice so you know the t is 2 over here again if we multiply p into t we get 400
so in this case what we notice is that mv is equal to pt what did fischer say
fisher said that when we and t we've assumed these to be constants remember in the assumptions we
study when v and t are constant in an economy then it is true that when money supply
increases price tends to increase in fact he called this as a truism that is a truth
or a fact it's he called it this as an identity he said this is definitely true you can just
think logically chap money pesa is bound to rise and of course then
value of money will bound to fall so this is the relation which you have to remember it is a fact and it is a true
what fisher had told us so now guys i've just drawn two very simple graphs for your
explanation and you might need to draw it if required in an exam so basically here we've shown the
relationship between price and money supply graphically we studied that both hold a direct
relationship so when we notice initially we are at om and op okay our x axis where we have money supply y
axis we have price so we notice when money supply increases from om to om dash a price
also rises from op to op dash and similarly vice versa when money supply falls our price also falls
thus our relationship is a direct relationship giving us a you know straight line curve whereas on
the other hand we have price and value of money which obviously have an inverse relationship with each
other we notice over here initially we are at ovm
which is the value of money i've taken it as vm and op price but we noticed when the price rises from
op to op dash or ob double dash i can say our value of money falls
from ovm to ovm double dash you know value of money is falling and similarly when the price falls our value of money
rises thus giving us a negatively inclined curve so this is just a simple uh you know
graphical explanation of the uh theory so lastly guys i would like to conclude the video with some criticisms
so in economics i've always taught you that criticisms are very much derived from assumptions so over here vnt which
were considered to be constant it was heavily criticized by the cancer economist that we
and t cannot be constants you know when population increases we is tending to increase obviously
circulation when natural resources or technology developments happen then t cannot be
constant next full employment is a very rare phenomena and it is not possible they've also neglected interest rate
over here so whenever you know we're talking about money supply and price interest rate is bound to come but here
they've totally depicted that role of interest rate then only applicable in the long run too
much emphasis on money supply has been given and lastly and most importantly as i said
money is only looked as a medium of exchange you know ignored the other functions of
money like store of value and you know speculative demand of money all that has been ignored
so this is what this theory is all about guys i hope this video was useful for you
please do like my video and subscribe to my channel and i hope to see you in the next video
pretty soon
Heads up!
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