Fisher’s Transactions Approach To Demand for Money –
Fisher in his theory of demand laid stress only on the medium of exchange function of money. All transactions such as buying goods, services, raw material, assets require payment of money as value and value paid in form of money must be equal to the value received such as value of goods, services, assets.
So, in any given period of time, the value of all goods, services or assets sold must equal to the number of transactions made multiplied by the average price of these transactions.
On the other hand, because value paid is identically equal to the money flow used for the purchasing goods, services and assets, the value of money flow is equal to the nominal quantity of money supply M multiplied by the average number of times the quantity of money in circulation is used for transactions purposes.
The average number of times a unit of money is used for transactions of goods, services or asset is called transactions velocity of circulation and is denoted by V.
Fisher’s equation of exchange –
MV = PT
M = the quantity of money in circulation
V = transactions velocity of circulation
P = average price
T = total number of transactions
By taking some assumptions about the variables V and T, Fisher transformed this equation into the theory of demand for money.
According to the Fisher, the nominal quantity of money is fixed by the central bank of a country. So it is treated as an exogenous variable which is assumed to be given in a particular period of time.
The number of transactions in a period is a function of national income, which means greater the national income, greater the number of transactions.
Fisher also assumed that there is full employment of resources in the economy, the level of national income is determined by the amount of fully employed resources, so with this assumption the volume of transactions is fixed in the short run.
Another important assumption of Fisher’s theory or equation is that velocity of circulation remains constant and is independent of M, P and T. According to him the velocity of circulation is determined by institutional and technological factors involved in the transactions process and these factors do not change much in the short run that’s why the transactions velocity of circulation of money (V) was assumed to be constant.
For money market to be in equilibrium, nominal quantity of money supply must be equal to the nominal quantity of money demand.
Then, Ms = Md = M
M is fixed by the central bank of a country.
So, the Fisher’s equation can be written as
Md = PT / V
According to Fisher’s transactions approach, demand for money depends on –
a. The number of transactions (T)
b. The average price of transactions (P)
c. The transaction velocity of circulation of money (V)
In Fisher’s theory of demand for money have some problems when it is used for empirical research.
First, Fisher’s theory also includes the transactions involving the sale and purchase of capital goods and assets such as securities, shares, land etc. Value of these assets changes frequently which will cause changes in T and T will not remain constant even if the income is taken to be constant due to the full employment assumption.
Second, it is difficult to define and determine the average price level which also includes the capital assets.