The Fisher’s 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=M’V). 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+M’V’. Thus the
equation of exchange is PT=MV+M’V’. 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+M’V’/T
• Fisher points out the 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.

• Fisher’s quantity theory of money is explained with the help of Figure

65.1. (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 M , the price level is also doubled
2

to P . Further, when the quantity of money is increased four-fold to M , the

2 4

price level also increases by four times to P . This relationship is expressed

4

by the curve P = f (M) from the origin at 45°.

In panel В 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 M  the value of money is HP.
1

But with the doubling of the quantity of money to M , the value of money
2

becomes one-half of what it was before, 1/P . And with the quantity of
2

money increasing by four-fold to M , the value of money is reduced by 1/P .

4 4

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:
Fisher’s 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.” Fisher’s equation of
exchange is a simple truism because it states that the total quantity of money
(MV+M’V’) 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
Fisher’s 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 Fisher’s equation are interrelated and
interdependent. For instance, a change in M may cause a change in V.
Consequently, the price level may change more in proportion to a change in the
quantity of money. Similarly, a change in P may cause a change in M. Rise in the
price level may necessitate the issue of more money. Moreover, the volume of
transactions T is also affected by changes in P. When prices rise or fall, the volume of
business transactions also rises or falls. Further, the assumptions that the proportion
M’ to M is constant, has not been borne out by facts. Not only this, M and M’ are not
independent of T. An increase in the volume of business transactions requires an
increase in the supply of money (M and M’).
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:
Fisher’s 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.
Prices may not rise despite increase in the quantity of money during depression; and
they may not decline with reduction in the quantity of money during boom. Further,
low prices during depression are not caused by shortage of quantity of money, and
high prices during prosperity are not caused by abundance of quantity of money. Thus,
“the quantity theory is at best an imperfect guide to the causes of the trade cycle in the
short period” according to Crowther.
6. Neglects Interest Rate:
One of the main weaknesses of Fisher’s quantity theory of money is that it neglects
the role of the rate of interest as one of the causative factors between money and
prices. Fisher’s equation of exchange is related to an equilibrium situation in which
rate of interest is independent of the quantity of money.
7. Unrealistic Assumptions:
Keynes in his General Theory severely criticised the Fisherian quantity theory of
money for its unrealistic assumptions. First, the quantity theory of money for its
unrealistic assumptions. First, the quantity theory of money is unrealistic because it
analyses the relation between M and P in the long run. Thus it neglects the short run
factors which influence this relationship. Second, Fisher’s equation holds good under
the assumption of full employment. But Keynes regards full employment as a special
situation. The general situation is one of the under-employment equilibrium. Third,
Keynes does not believe that the relationship between the quantity of money and the
price level is direct and proportional.
Rather, it is an indirect one via the rate of interest and the level of output. According
to Keynes, “So long as there is unemployment, output and employment will change
in the same proportion as the quantity of money, and when there is full employment,
prices will change in the same proportion as the quantity of money.” Thus Keynes
integrated the theory of output with value theory and monetary theory and criticised
Fisher for dividing economics “into two compartments with no doors and windows
between the theory of value and theory of money and prices.”
8. V not Constant:
Further, Keynes pointed out that when there is underemployment equilibrium, the
velocity of circulation of money V is highly unstable and would change with changes
in the stock of money or money income. Thus it was unrealistic for Fisher to assume V
to be constant and independent of M.
9. Neglects Store of Value Function:
Another weakness of the quantity theory of money is that it concentrates on the
supply of money and assumes the demand for money to be constant. In order words,
it neglects the store-of-value function of money and considers only the medium-of-
exchange function of money. Thus the theory is one-sided.
10. Neglects Real Balance Effect:
Don Patinkin has critcised Fisher for failure to make use of the real balance effect,
that is, the real value of cash balances. A fall in the price level raises the real value of
cash balances which leads to increased spending and hence to rise in income, output
and employment in the economy. According to Patinkin, Fisher gives undue
importance to the quantity of money and neglects the role of real money balances.
11. Static:
Fisher’s theory is static in nature because of its such unrealistic assumptions as long
run, full employment, etc. It is, therefore, not applicable to a modern dynamic
economy.