Model Answer
0 min readIntroduction
The Quantity Theory of Money (QTM) is a cornerstone of classical macroeconomic thought, attempting to explain the relationship between the money supply and the price level. Irving Fisher, in his ‘The Purchasing Power of Money’ (1911), initially formulated this theory, positing a direct and proportional relationship between the quantity of money and the general price level. However, Fisher’s theory faced criticisms, particularly regarding the instability of the velocity of money. Milton Friedman, a prominent monetarist, later refined this theory, arguing that his version was not a departure but rather a ‘restatement’ of Fisher’s original insights, addressing the shortcomings and making it more relevant for modern economies.
Fisher’s Quantity Theory of Money
Fisher’s QTM is expressed by the equation of exchange: MV = PT, where:
- M represents the money supply
- V represents the velocity of money (the rate at which money changes hands)
- P represents the general price level
- T represents the volume of transactions
Fisher assumed that V was stable and determined by institutional factors, and T was largely determined by real factors like population and productivity. Therefore, changes in M directly and proportionally affected P. This implied a strong causal link between money supply and inflation.
Friedman’s Restatement
Friedman agreed with the fundamental principle of the QTM – that changes in the money supply ultimately lead to changes in the price level. However, he argued that Fisher’s assumption of a stable V was unrealistic, especially in the short run. Friedman’s key contribution was to emphasize that V is not constant but is predictable and stable in the long run. He argued that people adjust their nominal spending plans based on anticipated changes in the money supply.
Friedman broadened the definition of ‘transactions’ (T) to include not just consumer transactions but also asset transactions. He also distinguished between ‘nominal income’ (PT) and ‘real income’ (T), arguing that changes in the money supply primarily affect nominal income in the short run, and only in the long run do they translate into changes in the price level. This is because individuals and firms initially respond to increased money supply by increasing both prices and output.
How Friedman’s Theory is a Restatement
Friedman’s restatement isn’t a rejection of Fisher’s theory but a refinement. Both theories share the core equation MV = PT. Friedman didn’t alter the equation; he focused on clarifying the underlying assumptions and addressing the criticisms leveled against Fisher’s original formulation.
Here’s a comparative table:
| Feature | Fisher’s Theory | Friedman’s Theory |
|---|---|---|
| Velocity of Money (V) | Assumed to be stable and constant | Stable in the long run, predictable, influenced by expectations |
| Transactions (T) | Focused on consumer transactions | Includes asset transactions; broader definition |
| Short-Run Impact of Money Supply | Directly affects price level | Affects nominal income (PT) |
| Long-Run Impact of Money Supply | Affects price level | Affects price level |
Essentially, Friedman acknowledged that the short-run relationship between money supply and price level is complex and influenced by factors like expectations and nominal rigidities. However, he maintained that in the long run, the fundamental relationship – as expressed by the equation of exchange – holds true, mirroring Fisher’s original insight.
Conclusion
In conclusion, Friedman’s contribution wasn’t to dismantle Fisher’s QTM but to modernize and strengthen it. By acknowledging the complexities of the short-run and emphasizing the role of expectations, Friedman provided a more nuanced and empirically relevant version of the theory. His restatement retained the core principle of a long-run relationship between money supply and price level, solidifying the QTM’s enduring influence on macroeconomic thought. The debate continues regarding the precise magnitude and timing of these effects, but the fundamental link remains a central tenet of monetarist economics.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.