By manipulation of the equation of Exchange:
MV = PT, Fishers stated P = MV/T, which implies that the quantity of money (M) determines the prices level (P) and the latter varies directly in proportion to the changes in the stock of money, assuming T and V to be constant.
In this equation of exchange, however, only primary money or currency money is conceived. But in the modern economy, money includes not only notes and coins, but also demand deposits of banks or credit money.
Consequently, Fisher has extended the equation of exchange to include bank deposits also. He denotes M for demand deposits in the bank money, and V for the velocity of circulation of bank money. Thus, the extended form of the equation of exchange is written as:
P = MV+M’V’/T
It is easy to see from this equation that the price level is determined by the following factors:
(a) The quantity of money in circulation (M);
(b) The velocity of circulation of money (V);
(c) The volume of bank money (M’);
(d) The velocity of circulation of bank money (V’); and
(e) The volume of trade or transactions, that is, v the amount of goods bought by money (T).
The equation further denotes that the price level (P) is directly related to M, V, M’ and V and it is inversely related to T.
The proposition declared fundamental to the quantity theory runs thus the prices level varies in proportion to the quantity of money.
Thus, the fundamental to the quantity theory runs thus the price level varies in proportion to the quantity of money.
Thus, the fundamental thesis which Prof. Fisher seeks to establish by the equation of exchange is that the price level or the value of money is a function of the quantity of money only. He regarded this equation as an important tool of analysis, including the correlation between the general price level the quantity of money.