5 Minute Economics: Quantity Theory of Money - Fisher's Approach

Introduction

Origin:
- Dates back to the 16th century
- Observed price increases in Europe due to increased money supply from America
Ivan Fisher's contribution:
- Introduced in his book "The Purchasing Power of Money" (1911)
- Key observation: Increased money supply leads to rising prices (inflation)
- Direct relationship between money supply and price: as money supply increases, prices increase
- Indirect relationship: increased money supply leads to a fall in the value of money

Fisher's Equation: MV = PT
- M: Money supply
- V: Velocity of money
- P: Average price level
- T: Volume of transactions

Velocity of money (V) remains constant
Volume of transactions (T) remains constant
Economy operates at full employment
Prices are passive (change due to other factors)
Money used only as a medium of exchange (ignores other functions like store of value)

Left side (Supply side):
- MV represents total money in circulation
  - Example: If M = 100 and V = 4, then MV = 400
Right side (Demand side):
- PT represents total money needed for transactions
  - Example: If price (P) = 200 and T = 2, then PT = 400
Fisher's conclusion: If V and T are constant, an increase in money supply leads to a rise in prices
- He termed this relationship as a "fact" or "identity"

Money Supply vs. Price
- Direct relationship: As money supply (x-axis) increases, price (y-axis) increases
Price vs. Value of Money
- Inverse relationship: As price increases, the value of money decreases

Critique from Keynesian economists:
- Velocity (V) and transactions (T) cannot remain constant
- Population growth affects V; technological developments affect T
Full employment is rarely achieved
Neglect of interest rates in the money supply and price relationship
Overemphasis on money supply fails to consider other functions of money