Question

Assume the national (nominal) income is expected to drop sharply over the next year but to recover afterwards. Using two money demand theories of your choice, please discuss what the impact of this income drop on the money demand would be. Discuss both theories in detail to demonstrate your reasoning.

Answer 1

In his theory of demand for money Fisher and other classical economists laid stress on the medium of exchange function of money, that is, money as a means of buying goods and services. All transactions involving purchase of goods, services, raw materials, assets require payment of money as value of the transaction made.

If accounting identity, namely value paid must equal value received is to occur, value of goods, services and assets sold must be equal to the value of money paid for them. Thus, in any given period, the value of all goods, services or assets sold must equal to the number of transactions 7 made multiplied by the average price of these transactions. Thus, the total value of transactions made is equal to PT.

On the other hand, because value paid is identically equal to the value of money flow used for buying 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 or exchanged for transaction purposes. The average number of times a unit of money is used for transactions of goods, services and assets is called transactions velocity of circulation and is denoted by V.

Symbolically, Fisher’s equation of exchange is written as under:

MV = PT …(1)

Where, M = the quantity of money in circulation

V = transactions velocity of circulation

P = Average price

T = the total number of transactions.

The above equation (1) is an identity, that is true by definition. However by taking some assumptions about the variables V and T, Fisher transformed the above identity into a theory of demand for money.

According to Fisher, the nominal quantity of money M is fixed by the Central Bank of a country (note that Reserve Bank of India is the Central Bank of India) and is therefore treated as an exogenous variable which is assumed to be a given quantity in a particular period of time.

Further, the number of transactions in a period is a function of national income; the greater the national income, the larger the number of transactions required to be made. Further, since Fisher assumed that full employment of resources prevailed in the economy, the level of national income is determined by the amount of the fully employed resources.

Thus, with the assumption of full employment of resources, the volume of transactions T is fixed in the short run. But most important assumption which makes Fisher’s equation of exchange as a theory of demand for money is that velocity of circulation (V) remains constant and is independent of M, P and T.

This is because he thought that velocity of circulation of money (V) is determined by institutional and technological factors involved in the transactions process. Since these institutional and technological factors do not vary much in the short run, the transactions velocity of circulation of money (V) was assumed to be constant.