What is the Criticism against Fisher’s Quantity Theory of Money

The Fisherian approach has been severely criticised as under:

1. The equation of exchange is just a mathematical truism:

The equation of exchange by itself provides no analytical clue to the determinants of the value of money. It says nothing about what determines what.

It is a mathematical identity, MV = PT, revealing that the turnover of money is always equal to the turnover of goods, i.e., money paid equals money received. Hence, the cash transactions equation is a truism or a self-evident proposition.

It is a statement of an obvious fact, because it states that money given in exchange for a good is equal to its price or value. It does not state anything about money or prices, or does not indicate which the cause is and which the effect is.

It indicates only the final stage of rise in the price level, but it does not explain the actual process as to how an increase in the quantity of money influences the price level stage by stage.

In other words, the transactions theory only states the relationship between the quantity of money and the price level, and it fails to explain the processes through which the quantity of money and the price level is not so simple and direct as Fisher assumes, but it is a highly complex phenomenon.

2. The price level (P) is wrongly assumed to be a passive factor:

The price level P is not passive as assumed by Fisher. In reality P may be active. P does influence T, because rising prices give profit incentives to business expansion, T would increase. Thus, a rise in P may increase the volume of trade which may cause an increase in the quantity of money and V.

3. The velocity of circulation of money (V) may not be a constant factor:

Fisher regards V as independent and constant. But, in practice V may vary with the volume of trade and price level, i.e., with P and T. V is also affected by the actual and expected changes in M or money supply.

Then, the effect of changes in M may be neutralised by an opposite change in V. Sometimes, M being constant, V may increase, causing the price level to rise. For instance, the hyper­inflation in Germany in 1923 was more as a result of the increase in the velocity of circulation rather than the increase in the money supply.

4. The assumption of full employment in unrealistic:

A fundamental objection raised by Keynes against the cash transactions approach is that it is based on the assumption of full employment, which is a rare possibility in a modern society.

When there are unemployed resources in the country, changes in M may not affect P as T also changes. As long as there are unemployed resources, every increase in the money supply would lead to an increase in real income or output.

But once full employment level is reached in the long period, the quantity of money will affect P. The quantity theory, thus, becomes a limiting case which holds good in the state of full employment only.

5. The equation of exchange has a technical inconsistency:

The significance of the equation of exchange in the theory is further reduced because it involves a sort of technical inconsistency in using M and V. M refers to money at a point of time, whereas V refers to the velocity of circulation over a period of time. Consequently, the extension of MV involves the inconsistency of multiplying two non-comparable factors.

6. The ultimate determinants of the value of money lie behind the equation of exchange and not in it:

According to Chandler, though M, V and T are assumed to be the immediate determinants of the price level, they are in no sense its ultimate determinants. Instead, they are themselves determined by a host of underlying objectives facts and human decisions.

Fisher has failed to go beyond the equation of exchange in examining the behaviour of the ultimate determinants of the value of money. Following Chandler, we may enlist some of them as under.

7. The Fisherian approach is mechanical and lacks human touch:

Fisher’s explanation is mechanical, because the theory gives an impression that the price level can be controlled by regulating the variables mentioned in the equation. In the equation, there is no scope for the decision of consumers and producers about saving and investment.

The human element is absent in the equation. And money has no will of its own; so if money supply increases, there is no guarantee that expenditure will also increase. In fact, it is’ the expenditure that determines the price level.

8. The transactions approach of the quantity theory of money is one-sided:

It considers the supply of money as the most effective, and assumes the demand for money to be constant, thereby neglecting the forces of demand for money, causing changes in the value of money.

Technically, the equation of exchange considered money only as a medium of exchange and ignored its important function as a store of value. In other words, factors determining the demand for money are not given due consideration.

9. The theory neglects the role of interest rate:

It is argued by critics like Mrs. Robinson that the quantity theory cannot be regarded as an adequate theory of money because it does not take into account the rate of interest.

“Changes in the quantity of money are of utmost importance, but their importance lies in their influence upon the rate of interest, and a theory of money which does not mention the rate of interest, is not a theory at all,” says Mrs. Robinson.

In fact, the relation between the quantity of money and the price level is indirect. An increase in the supply of money reduces the interest rate which would encourage a greater investment expenditure which along with the consumption expenditure would determine the price level.

10. Theoretical dichotomy into theory of money and the theory of value:

Keynes observed that the equation MV = PT artificially divorces the theory of money from the general theory of value.

11. The Fisherian approach is static:

It is inapplicable to modern dynamic conditions.

12. The Equation of Exchange has a technical inconsistency:

As Prof. G.N. Halm points out, the expression MV in the question involves the inconsistency of multiplying non-comparable factors such as M and V.

This is because, the stock of money M refers to a point of time; whereas, the velocity of circulation V refers to the turnover of money during a period of time. Fisher, thus, illogically multiplies a point concept (M) with a period concept (V).

Besides, the Fisherian version of quantity theory of money has been rejected on empirical grounds also. Evidences simply do not corroborate the hypothesis that the price level varies directly and proportionately with the quantity of money.

In fact, it has been noticed that the prices have risen even though there has been no change in money supply; and prices have fallen (during a depression) Inspite of increased stock of money and prices have moved upward, as in Indian economy, though the variation has not been in exact proportion.

According to the more virulent critics, even if the prices and money stock were found to have perfect positive correlation empirically, it cannot be accepted as a thesis that the variation in money supply causes a proportional variation in price level at all times.