The value of money is the quantity of goods and services in general that will be exchanged for a unity of money. The value of money indicates its purchasing power, i.e., the quantity of goods and services that a unit of money can purchase. The value of money has inverse relation with the general level of prices in a country. When general price level raises, the value of money falls and when general price-level falls, the value of money rises. There are three approaches explaining the value of money.
Cash-Transactions Approach (The quantity theory of money):
The value of money, like that of any other commodity, is determined by forces of supply and demand. The value of money varies, other things being equal, inversely as its supply and directly as its demand. The supply of money consists of the total quantity of money and its velocity. Velocity of money means the number of times a money unit changes hands. If, for instance, during a given period, a hundred rupees note changes hand ten times, then the quantity of money in this case will be thousand rupees (Rs. 100*10) and not Rs. 100.
The demand for money is stated as the sale of commodities, services and property rights in exchange for money. Thus, there are three immediate determinants of the value of money; the average quantity of money available, its average velocity and the demand for money.
The theory states, that every change in the quantity of money in circulation produces, other things being equal, directly proportional change in the general price level or reverse proportional change in the value of money. In other words, the general level price varies inversely to the value of money and directly to the supply of money, if the quantity of money will be reduced to half. This concept is explained by Prof. Irving Fisher in his book “The purchasing power of Money”.
Fisher’s equation of exchange:
MV=PT
i.e, Supply of Money = Demand for Money
or, P=MV/T
M is the money quantity in circulation, both coins and paper but excluding bank reserves and money held by treasury.
V stands for the velocity of money in circulation and is obtained by dividing the total money payments in a given period by the units of money in circulation. P represents the general price level.
T refers to the aggregate volume of transaction for which money payments are made. It is equivalent to the physical volume of trade.
In modern economy, money consists of not only the notes and coins, but also bank deposits. Consequently, Fisher extended the scope of the equation to include bank deposits. If M1 stands for bank money and V1 stands for velocity of bank money then the above equation becomes:
MV+M1V1=PT
Or, P= MV +M1V1/T
Assumptions:
Fisher’s Formula is based on certain assumptions. They are-
- Price is determined by the other terms in the equation, it does not determine them.
- M1 is the function of lawful money M.
- A change in M has normally no effect on velocity V.
- A change in the quantity of money does not affect the volume of trade.
Asst.Prof.of Manegment —-Subhrashek Dey .
