Quantity Theory
Fisher’s view that velocity is fairly constant in the short run transforms the equation of exchange into the quantity theory of money, which states that nominal income is determined solely by movements in the quantity of money: When the quantity of money M doubles, M x V doubles and so must P x Y, the value of nominal income. To see how this works, let’s assume that velocity is 5, nominal income (GDP) is initially $5 trillion, and the money supply is $1 trillion. If the money supply doubles to $2 trillion, the quantity theory of money tells us that nominal income will double to $10 trillion (= 5 x $2 trillion).
Because the classical economists (including Fisher) thought that wages and prices were completely flexible, they believed that the level of aggregate output Y produced in the economy during normal times would remain at the full employment level, so V in the equation of exchange could also be treated as reasonably constant in the short run. The quantity theory of money then implies that if M doubles, P must also double in the short run because V and Y are constant. In our example, if aggregate output is $5 trillion, the velocity of 5 and a money supply of $1 trillion indicate that the price level equals 1 because 1 times $5 trillion equals the nominal income of $5 trillion. When the money supply doubles to $2 trillion, the price level must also double to 2 because 2 times $5 trillion equals the nominal income of $10 trillion.
For the classical economists, the quantity theory of money provided an explanation of movements in the price level: Movements in the price level result solely from changes in the quantity of money.
Quantity Theory of Money Demand
Because the quantity theory of money tells us how much money is held for a given amount of aggregate income, it is in fact a theory of the demand for money. We can see this by dividing both sides of the equation of exchange by V, thus rewriting it as
M d= l/ V×PY
where nominal income P x Y is written as PY. When the money market is in equilibrium, the quantity of money M that people hold equals the quantity of money demanded Af, so we can replace M in the equation by Md. Using Tag Heuer Carrera Replica k to represent the quantity I/ V (a constant because V is a constant), we can rewrite the equation as
M = k x PY
Equation 3 tells us that because k is a constant, the level of transactions generated by a fixed level of nominal income PY determines the quantity of money if that people demand. Therefore, Fisher’s quantity theory of money suggests that the demand for money is purely a function of income, and interest rates have no effect on the demand for money.
Fisher came to this conclusion because he believed that people hold money only to conduct transactions and have no freedom of action in terms of the amount they want to hold. The demand for money is determined by the level of transactions generated by the level of nominal income PY and by the institutions Tag Heuer Replica Watches in the economy that affect the way people conduct transactions that determine velocity and hence k.
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