Hom Nath Gaire
Irving Fisher, in 1911, came up with an equation of money and formalized the foundations of the quantity theory of money based on the ideas of some classical economists headed by John Stuart Mill and Simon Newcomb. However, he was the pioneer to come out with a mathematical model of how the dynamics of money supply impacts the general price level in an economy.
Fisher’s equation for money, which he borrowed from physics to explain the Quantity Theory of Money as the "equation of exchange" in economics, is: . Here M is the quantity of money, V is the velocity of money, P is the general price level of an economy and T is the volume of transactions of goods and services produced in the economy. This equation of exchange means that the total amount of money in an economy multiplied by its velocity (how fast it circulates) is equal to the total spending.
This simple mathematical formulation of an extremely complex process explains how money supply in an economy impacts the economic growth and livelihood of people, remained hidden for almost five decades before it got revive by an American Monetarist Milton Friedman, in the mid nineteen fifties. Under Monetarist school of thought, Friedman founded with Anna Schwartz, the Fisher equation became: where Q is the index of real value of final expenditures in an economy. Therefore, quantity of money times the velocity of money is the economic output or the GDP of an economy. Friedman became convinced with the Fisher’s equation of money and generalized its conclusion, the quantity of money supplied by the monetary authority is key to understand all problems in economics based on the premise that "money matters".
According to the quantity theory of money, the only thing that matters in an economy is the supply of money. Assuming velocity of money (V) and GDP (Q) constant, there is direct and proportional relationship between money supply (M) and general price level (P). It means if the money supply increases with out additional production of goods and services (GDP) then the general price level (inflation) will be increased proportionately. Because, no additional of goods and services would be available to be purchased from the surplus amount of money and people will be ready to pay more than before for the same quantity of product.
Although, the quantity theory of money is based on an assumption of full employment economy, most of the central banks of developed as well as developing countries have been following it as the policy guide while formulating their monetary policy. Not only the central banks of the respective countries, but also the international organizations such as; World Bank, International Monetary Fund (IMF), Asian Development Bank (ADB), UNDP etc. have been using the quantity theory for their policy formulation purpose. Like wise, various research institutions and independent researchers have been exploiting the theory as the reference of their research works.
The Quantity theory of money works only if the "velocity of money", V, is constant then we can measure the change in P, Q and P*Q by changing M, the money supply. But, according to Rahul Bhattacharya, an Indian thinker, nobody quite knew how this "velocity of money", V, behaved. ‘At best, it was not constant and could vary substantially from one period to another. If V is not constant then the equation of money runs aground,’ he noted on his article, “Quantity Theory of Money- Fisher Friedman Illusion”. Hence, if V is not constant then a change in M can be offset by a change in V in such a way that P*Q does not change at all. And if that happens, then the theory would be worthless, for the economic policy makers and thinker with the supply of money in the economy to influence the prices in the long run and both the prices and the economic output in the short run.
Nepal had clued-up the same situation, as mentioned by Mr. Bhattacharya, in the Fiscal Year 2009/10, the bitterest year for Nepal’s financial system at some point in its modern era of 25 years. During this year, extremely a smaller amount of physical money was circulating in the economy, because, money stayed behind with the people’s vault. They felt comfortable to hoard liquid cash (money) or used to invest in alien market through unofficial canal, resulting shortage of liquid assets or cash in the country’s banking system. The root cause of this situation was people’s confusion about the government policies, financial ups and downs along with less confidence on bank deposits. Due to this reason, there was too little cash and other current assets required to pay current liabilities as they mature fell out the economy in to liquidity crunch.
This liquidity crunch was caused due to sharp decline in the “velocity of money”, V, in comparison to the previous years. This hindered the economic activities of all niches and corner of the economy and ultimately lowered down the Gross Domestic Product (GDP) for the year. Let’s put side by side the Nepal’s factual state of affairs with the spirit of the Quantity Theory of Money. The theory states that there is direct and proportional relation between quantity of money ‘M’ and the general price level ‘P’ assuming ‘V’ and ‘Q’ constant. But there was just opposite situation or direct relationship between ‘V’ and ‘Q’ indicating by lower ‘Q’ due to lower ‘V’ with more or less same ‘M’ and ‘P’. In such a situation, it can be said that the Quantity Theory of Money could not hold in Nepal and failed. Because it had been observed in Nepal, there is direct but not proportional relationship between the velocity of money and GDP of the Economy.
Milton Friedman, of course, understood this very well. Not only did he resurrect the Fisher equation he set out on a bold mission with his colleague to analyze the monetary history of the United States. His mission was to establish that the velocity of money was in fact very stable. He wanted to test the classical notion that ‘V’ was stable and wanted to test this via empirical estimates. He concluded, after long and tiring research and quite a lot of fancy math, that the velocity of money ‘V’ was indeed stable and was independently determined from ‘T’ the number of transactions in the economy.
By the same way, this is the right time to establish the validity of the Quantity Theory of Money in the Nepalese context. At the same time, this is an opportunity as well as challenge to the Nepalese Economists and Scholars to test the validity of the Theory in our context through an empirical study.
Irving Fisher, in 1911, came up with an equation of money and formalized the foundations of the quantity theory of money based on the ideas of some classical economists headed by John Stuart Mill and Simon Newcomb. However, he was the pioneer to come out with a mathematical model of how the dynamics of money supply impacts the general price level in an economy.
Fisher’s equation for money, which he borrowed from physics to explain the Quantity Theory of Money as the "equation of exchange" in economics, is: . Here M is the quantity of money, V is the velocity of money, P is the general price level of an economy and T is the volume of transactions of goods and services produced in the economy. This equation of exchange means that the total amount of money in an economy multiplied by its velocity (how fast it circulates) is equal to the total spending.
This simple mathematical formulation of an extremely complex process explains how money supply in an economy impacts the economic growth and livelihood of people, remained hidden for almost five decades before it got revive by an American Monetarist Milton Friedman, in the mid nineteen fifties. Under Monetarist school of thought, Friedman founded with Anna Schwartz, the Fisher equation became: where Q is the index of real value of final expenditures in an economy. Therefore, quantity of money times the velocity of money is the economic output or the GDP of an economy. Friedman became convinced with the Fisher’s equation of money and generalized its conclusion, the quantity of money supplied by the monetary authority is key to understand all problems in economics based on the premise that "money matters".
According to the quantity theory of money, the only thing that matters in an economy is the supply of money. Assuming velocity of money (V) and GDP (Q) constant, there is direct and proportional relationship between money supply (M) and general price level (P). It means if the money supply increases with out additional production of goods and services (GDP) then the general price level (inflation) will be increased proportionately. Because, no additional of goods and services would be available to be purchased from the surplus amount of money and people will be ready to pay more than before for the same quantity of product.
Although, the quantity theory of money is based on an assumption of full employment economy, most of the central banks of developed as well as developing countries have been following it as the policy guide while formulating their monetary policy. Not only the central banks of the respective countries, but also the international organizations such as; World Bank, International Monetary Fund (IMF), Asian Development Bank (ADB), UNDP etc. have been using the quantity theory for their policy formulation purpose. Like wise, various research institutions and independent researchers have been exploiting the theory as the reference of their research works.
The Quantity theory of money works only if the "velocity of money", V, is constant then we can measure the change in P, Q and P*Q by changing M, the money supply. But, according to Rahul Bhattacharya, an Indian thinker, nobody quite knew how this "velocity of money", V, behaved. ‘At best, it was not constant and could vary substantially from one period to another. If V is not constant then the equation of money runs aground,’ he noted on his article, “Quantity Theory of Money- Fisher Friedman Illusion”. Hence, if V is not constant then a change in M can be offset by a change in V in such a way that P*Q does not change at all. And if that happens, then the theory would be worthless, for the economic policy makers and thinker with the supply of money in the economy to influence the prices in the long run and both the prices and the economic output in the short run.
Nepal had clued-up the same situation, as mentioned by Mr. Bhattacharya, in the Fiscal Year 2009/10, the bitterest year for Nepal’s financial system at some point in its modern era of 25 years. During this year, extremely a smaller amount of physical money was circulating in the economy, because, money stayed behind with the people’s vault. They felt comfortable to hoard liquid cash (money) or used to invest in alien market through unofficial canal, resulting shortage of liquid assets or cash in the country’s banking system. The root cause of this situation was people’s confusion about the government policies, financial ups and downs along with less confidence on bank deposits. Due to this reason, there was too little cash and other current assets required to pay current liabilities as they mature fell out the economy in to liquidity crunch.
This liquidity crunch was caused due to sharp decline in the “velocity of money”, V, in comparison to the previous years. This hindered the economic activities of all niches and corner of the economy and ultimately lowered down the Gross Domestic Product (GDP) for the year. Let’s put side by side the Nepal’s factual state of affairs with the spirit of the Quantity Theory of Money. The theory states that there is direct and proportional relation between quantity of money ‘M’ and the general price level ‘P’ assuming ‘V’ and ‘Q’ constant. But there was just opposite situation or direct relationship between ‘V’ and ‘Q’ indicating by lower ‘Q’ due to lower ‘V’ with more or less same ‘M’ and ‘P’. In such a situation, it can be said that the Quantity Theory of Money could not hold in Nepal and failed. Because it had been observed in Nepal, there is direct but not proportional relationship between the velocity of money and GDP of the Economy.
Milton Friedman, of course, understood this very well. Not only did he resurrect the Fisher equation he set out on a bold mission with his colleague to analyze the monetary history of the United States. His mission was to establish that the velocity of money was in fact very stable. He wanted to test the classical notion that ‘V’ was stable and wanted to test this via empirical estimates. He concluded, after long and tiring research and quite a lot of fancy math, that the velocity of money ‘V’ was indeed stable and was independently determined from ‘T’ the number of transactions in the economy.
By the same way, this is the right time to establish the validity of the Quantity Theory of Money in the Nepalese context. At the same time, this is an opportunity as well as challenge to the Nepalese Economists and Scholars to test the validity of the Theory in our context through an empirical study.
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