Value of Money and the Price Level –
Value of money means its purchasing power in terms of goods and services in general. It depends on the prevalent price level. If the prices are high, the value of money will be low. Conversely, if the prices are low, money will buy more and the value of money will be high.
The value of money is inversely proportional to the price level or we can say that the value of money is the reciprocal of the price level.
Quantity Theory of Money – Fisher’s Transactions Approach –
An American economist, Irving Fisher put forward the theory which states that the increase in the quantity of money leads to the rise in the general price level. He believed that the greater the quantity of money, the higher the level of prices and vice versa. This theory links the prices with the quantity of money, that’s why it is called quantity theory of money.
In simple terms, the quantity theory of money says that the level of prices varies directly with the quantity of money. For example –
If we double the quantity of money, and other things being equal, prices will be twice as high as before and the value of money will be one half.
If we halve the quantity of money, and other things being equal, prices will be one half of what they were before and the value of money will be double.
This theory states that, the price level rises proportionality with a given increase in the quantity of money, other things remaining the same and vice versa.
There are various factors which determine the value of money and the general price level.
The main factors which influence the general price level are –
1. The volume of trade or transactions
2. The quantity of money
3. Velocity of circulation of money.
1. The volume of trade or transactions depends on the supply of goods and services to be exchanged. The greater the supply of goods and services in the economy, the larger the number of transactions and trade and vice versa.
But the classical and neo classical economists believed that there is full employment of all resources in the economy. So, the total output or supply of goods cannot increase. Therefore, the total volume of transactions and trade will remain same.
2. The quantity of money in the economy consists of not only the notes and currency issued by the government or central bank but also the amount of credit or deposits created by the banks.
3. Velocity of circulation – A unit of money is used for transactions and exchange purposes not once but many times in a year. During these many exchanges of goods and services, a unit of money passes from one hand to another.
Velocity of circulation of money is the number of times a unit of money changes hands during exchanges in a year.
For example, if a single rupee is used five times in a year for exchange of goods and services, then the velocity of circulation is 5.
Fisher’s Equation of Exchange –
Fisher expressed the relation between the quantity of money and the price level in the form of an equation, which is called the equation of exchange.
PT = MV
P = MV/T
P = average price level
T = total amount of transactions
M = quantity of money
V = transactions velocity of circulation of money
MV represents the money spent on transactions
PT represents the money received from transactions