• Fisher’s Equation of Exchange:

The transactions version of the quantity theory of money was provided by the American
economist Irving Fisher in his book- The Purchasing Power of Money (1911). According to
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”.

Fisher’s quantity theory is best explained with the help of his famous equation of
exchange:

MV = PT or P = MV/T

Like other commodities, the value of money or the price level is also determined by the
demand and supply of money.

i. Supply of Money:
The supply of money consists of the quantity of money in existence (M) multiplied by the
number of times this money changes hands, i.e., the velocity of money (V). In Fisher’s
equation, V is the transactions velocity of money which means the average number of times a
unit of money turns over or changes hands to effectuate transactions during a period of time.
Thus, MV refers to the total volume of money in circulation during a period of time. Since
money is only to be used for transaction purposes, total supply of money also forms the total
value of money expenditures in all transactions in the economy during a period of time.
ii. Demand for Money:
Money is demanded not for its own sake (i.e., for hoarding it), but for transaction purposes.
The demand for money is equal to the total market value of all goods and services transacted.
It is obtained by multiplying total amount of things (T) by average price level (P).
Thus, Fisher’s equation of exchange represents equality between the supply of money or the
total value of money expenditures in all transactions and the demand for money or the total
value of all items transacted.
Supply of money = Demand for Money
Or
Total value of money expenditures in all transactions = Total value of all items transacted
MV = PT
or
P = MV/T
Where,
M is the quantity of money
V is the transaction velocity
P is the price level.
T is the total goods and services transacted.
The equation of exchange is an identity equation, i.e., MV is identically equal to PT (or MV
= PT). It means that in the ex-post or factual sense, the equation must always be true. The
equation states the fact that the actual total value of all money expenditures (MV) always
equals the actual total value of all items sold (PT).
What is spent for purchases (MV) and what is received for sale (PT) are always equal; what
someone spends must be received by someone. In this sense, the equation of exchange is not
a theory but rather a truism.
Irving Fisher used the equation of exchange to develop the classical quantity theory of
money, i.e., a causal relationship between the money supply and the price level. On the
assumptions that, in the long run, under full-employment conditions, total output (T) does not
change and the transactions velocity of money (V) is stable, Fisher was able to demonstrate a
causal relationship between money supply and price level.
In this way, Fisher concludes, “… the level of price varies directly with the quantity of
money in circulation provided the velocity of circulation of that money and the volume of
trade which it is obliged to perform are not changed”. Thus, the classical quantity theory of
money states that V and T being unchanged, changes in money cause direct and proportional
changes in the price level.
Irving Fisher further extended the equation of exchange so as to include demand (bank)
deposits (M’) and their velocity, (V’) in the total supply of money.
Thus, the equation of exchange becomes:

Thus, according to Fisher, the level of general prices (P) depends exclusively on five
definite factors:
(a) The volume of money in circulation (M);
(b) Its velocity of circulation (V) ;
(c) The volume of bank deposits (M’);
(d) Its velocity of circulation (V’); and
(e) The volume of trade (T).
The transactions approach to the quantity theory of money maintains that, other things
remaining the same, i.e., if V, M’, V’, and T remain unchanged, there exists a direct and
proportional relation between M and P; if the quantity of money is doubled, the price level
will also be doubled and the value of money halved; if the quantity of money is halved, the
price level will also be halved and the value of money doubled.

Assumptions:
1. V and V’ are assumed to be constant and are independent of changes in M and M’.
2. T is constant and independent of other factors like M, M’,V and V’
3. P is a passive factor and is affected by other factors in the equation.
4. It is assumed that demand for money is proportional to the value of transactions.
5. The supply of money is assumed as an exogenously determined constant.
6. The theory is applicable in the long run
7. It is based on the assumption of existence of full employment in the economy
Criticisms of Quantity Theory of Money:
The quantity theory of money as developed by Fisher has been criticised on the
following grounds:
1. Interdependence of Variables:
The various variables in transactions equation are not independent as assumed by the
quantity theorists:
(i) M Influences V – As money supply increases, the prices will increase. Fearing further rise
in price in future, people increase their purchases of goods and services. Thus, velocity of
money (V) increases with the increase in the money supply (M).
(ii) M Influences V’ – When money supply (M) increases, the velocity of credit money (V’)
also increases. As prices increase because of an increase in money supply, the use of credit
money also increases. This increases the velocity of credit money (V’).
(iii) P Influences T – Fisher assumes price level (P) as a passive factor having no effect on
trade (T). But, in reality, rising prices increase profits and thus promote business and trade.
(iv) P Influences M – According to the quantity theory of money, changes in money supply
(M) is the cause and changes in the price level (P) is the effect. But, critics maintain that a
change in the price level occurs independently and this later on influences money supply.
(v) T Influences V – If there is an increase in the volume of trade (T), it will definitely
increase the velocity of money (V).
(vi) T Influences M – During prosperity growing volume of trade (T) may lead to an increase
in the money supply (M), without altering the prices.
(vii) M and T are not Independent – According to Keynes, output remains constant only
under the condition of full employment. But, in reality less-than-full employment prevails
and an increase in the money supply increases output (T) and employment.

2. Unrealistic Assumption of Long Period: Keynes has aptly remarked that “in the long-run
we are all dead”. Actual problems are short-run problems. Thus, quantity theory has no
practical value.
3. Fails to Explain Trade Cycles: It does not tell why during depression the prices fall even
with the increase in the quantity of money and during the boom period the prices continue to
rise at a faster rate in spite of the adoption of tight money and credit policy.
4. Ignores Other Determinants of Price Level: It ignores the importance of many other
determinates of prices, such as income, expenditure, investment, saving, consumption,
population, etc.
5. One-Sided Theory:
Fisher’s transactions approach is one- sided. It takes into consideration only the supply of
money and its effects and assumes the demand for money to be constant. It ignores the role of
demand for money in causing changes in the value of money.

6. Crowther’s Criticism:
Prof. Crowther has criticised the quantity theory of money on the ground that it explains only
‘how it works’ of the fluctuations in the value of money and does not explain ‘why it works’
of these fluctuations. 

7.Based on unrealistic assumption of full employment

● Cambridge Cash Balance Approach

Demand for money
Store value of money
Discarded velocity of circulation

Classical approach - Demand for money

The classical economists did not explicitly formulate demand for money theory but their
views are inherent in the quantity theory of money. They emphasized the transactions
demand for money in terms of the velocity of circulation of money. This is because money
acts as a medium of exchange and facilitates the exchange of goods and services. In Fisher's
Equation of Exchange
MV = PT

where

M = total quantity of money

V = circulation velocity of money

P = price level

T = total amount of goods and services exchanged in form of money

The right hand side of this equation PT represents the demand for money which, in fact,
"depends upon the value of the transaction to be undertaken in the economy, and is equal to a
constant fraction of those transaction." MV represents the supply of money which is given
and in equilibrium equals the demand for money. Thus the equation becomes

Md = PT

This transactions demand for money, in turn, is determined by the level of full employment
income. This is because the classicists believed in Say's Law whereby supply created its
own demand, assuming the full employment level of income. Thus the demand for money in
Fisher's approach is a constant proportion of the level of transactions, which in turn, bears a
constant relationship to the level of national income.

The Cambridge Cash Balances Approach

As an alternative to Fisher's quantity theory of money, Cambridge economists Marshall,

Pigou, Robertson and Keynes theory, they regarded the determination of value of money in
terms of supply and demand.

The supply of money is exogenously determined at a point of time by the banking system.
Therefore, the concept of velocity of circulation is altogether discarded in the cash balances
approach because it 'obscures the motives and decisions of people behind it. On the other
hand, the concept of demand for money plays the major role in determining the value of
money. The demand for money is the demand to hold cash balances for transactions and
precautionary motives.

Thus the cash balances approach considers the demand for money not as a medium of
exchange but as a store of value. The Cambridge equations show that given the supply of
money at a point of time, the value of money is determined by the demand for cash balances.
When the demand for money increases, people will reduce their expenditure on goods and
services in order to have larger cash holdings. Reduced demand for goods and services will
bring down the price level and raise the value of money. On the contrary, fall in the
demand for money will raise the price level and lower the value of money.

Pigou's equation

PM=KR
P=KR/M
Where 
P= purchasing power of money or the value of money.
K=the proportion of total real resources or income (R) which people wish to hold in the form
of titles to legal tender
R=the total resources or real income
M=the number of actual units of legal tender money (CB money supply)

Cash balance approach versus transactions approach

The Cambridge cash balances approach to the quantity theory of money is superior to Fisher's
transactions approach in many respects. They are discussed as below.

The cash balances approach emphasises the importance of holding cash balances rather than
the supply to money which is given at a point to time. It thus led Keynes to propound his
theory of liquidity preference and of the rate of interest, and to the integration of monetary
theory with the theory of value and output.

The cash balances version of quantity theory is superior to the transactions version because
the former determines the value of money. But in the transactions approach, the
determination of value of money is artificially divorced from the theory of value.

The cash balances approach is superior to the transactions approach because it altogether
discards the concepts of velocity of circulation of money which 'Obscures the motives and
decisions of people behind it.'

Again the cash balances version is more realistic than the transactions version of the quantity
theory, because it is related to the short period while the latter is related to the long period.

In the cash balances equation, transactions relating to final goods only are included which is
the price level of final goods. On the other hand, in the transactions equation P includes all
types of transactions. This creates difficulties in determining the true price level.