Fisher proceeds to analyse the equation of exchange along with its assumptions in the following manner:
1. The price level (P) is a passive variable:
This means that P does not change by itself. It is determined and controlled solely by the other elements in the equation and it exerts no control over them. An increase in M or V alone will raise the price level, and vice versa, an increase in T alone will reduce the price level.
2. The total volume of transactions (T) is an independent but constant variable in the short run:
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It is not affected by any change in the quantity of money (M) and other factors in the equation, for, as Fisher says, T depends upon natural resources, technological development, population, etc., which are outside the equation so that any change in M will have no effect on T.
The factor T can be regarded as constant over short periods of time. Since T is affected by various outside factors which normally change only slowly over time, it is not subject to rapid fluctuations.
3. The velocity of circulation of money, V, is an independent element in the equation and is constant in the short period:
Normally, any change in M has no effect on V, for it depends upon outside factors such as payment habits of individuals and commercial customs, density of population, development of transportation.
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Since these factors, especially the monetary habits of the people, do not change immediately, normally V is quite a stable phenomenon so that any change in M will have no effect on. Likewise V is not affected by M’.
4. The ratio M’/M is constant:
The magnitude of bank money (MO depends on the commercial banks’ credit creation activity which in effect is a function of the currency money (M). M’ is assumed to be a constant factor since the ratio M’/M’, that is, the ratio of credit money to cash remains constant during the short period.
According to Fisher, under any given conditions of industry and civilisation, deposits tend to hold a fixed normal ratio to money in circulation. Thus, the inclusion of M’ does not normally disturb the quantitative relation between money and prices.
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5. Full Employment:
Assumption of full employment condition in the economy is implicit in the Fisherian analysis.
6. Short Period Analysis:
Fisher categorically viewed this theory on the basis of short period consideration of changes in the variables like M, V, P and T and held V and T to be the constant elements in his equation of exchange.
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When all the elements M’, V, V and T are constant and P is passive in the equation of exchange, it becomes clear that any fluctuation in the price level, P, is due to the fluctuations in M, the supply of quantity of money only.
Fisher then establishes a direct relationship between the price level and the quantity of money of such a nature that the purchasing power of money becomes an immediate inverse function of its quantity.
It follows, thus, that the price level varies exactly directly and the value of money varies inversely with changes in the money supply.