Equation of Exchange

The Quantity Theory of Money and the Equation of Exchange:

The Quantity Theory of Money was originated by Irving Fisher. In its original form, the quantity theory defines, “prices always modify in exact proportion to changes in the amount of money. When the amount of money is doubled, prices also double. When the amount of money is halved, the prices drop to half their original level”. The major point concerning the quantity theory is that price level modifies as of the modifications in the amount of money.

Equation of Exchange:

The quantity theory of money has been place forward in the form of an equation termed as the “Equation of Exchange”. It is also termed as Fisher’s equation. The equation of exchange defines that when ‘M’ is the amount of money, then ‘V’ is the velocity of circulation of money, ‘P’ is the price level and ‘T’ is the volume of trade, then,

MV = PT (or P = MV/T)

This is termed as the equation of exchange. The velocity of circulation (V) refers to the number of times that all unit of money is employed during a given time period. The equation states whenever the supply of money rises, other things being equivalent, there will be an increase in the price level. It means a fall in the value of money. For illustration, whenever ‘M’ is doubled, ’P’ will be doubled.

These days, a large proportion of money comprises of cheques, bills and other forms of credit instruments. Therefore some economists are of the opinion that the above kinds of money must be taken into account while considering the amount of money. Therefore the Equation of Exchange has been altered as shown below:

PT = MV + M1V1

M1 is the net amount of all forms of cheques, bills & other instruments of credit in circulation and
V1 is the velocity of the circulation of M1 (i.e., credit instruments). 

The main criticism alongside the quantity theory of money is that it depends on the supposition of full employment. However if full employment is not there and when there are unemployed resources, a rise in the quantity of money will not usually raise prices.

Again, during depression, all prices drop. Even when the quantity of money is raised at that time, prices will not mount. Despite the above criticism, we might note that the quantity theory of money is a statement of propensity and it points out in a crude manner the relationship among prices and the quantity of money.

Changes in price level might be influenced by numerous things other than the quantity of money like Government’s monetary and fiscal policy, the supply of goods in the specified period, the volume of trade, modifies in the incomes of the people and effective demand for goods. One way of studying concerning changes in prices is to study regarding inflation and deflation.

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