Management Notes

Reference Notes for Management

Fisher equation of exchange states that

Fisher equation of exchange states that

    1. P varies directly with income
    2. P varies directly with M
    3. P and M are constants
    4. None of the above

Correct Answer: P varies directly with M

 Answer Explanation

An economy’s money supply (M), velocity of money (V), price level (P), and volume of transactions (T) are related by the Fisher equation of exchange.

In this equation, the left-hand side (MV) represents the total nominal spending in the economy, which is the product of the money supply and the velocity of money. As a product of price level and volume of transactions, the right-hand side (PT) represents the total nominal value of transactions in the economy.

The correct answer is (b) P varies directly with M, which means that the price level (P) is directly proportional to the money supply (M). Inflation occurs when the money supply increases, all else being equal. Conversely, if the money supply decreases, the price level tends to fall, leading to deflation.

Why the other options are not correct

a. P varies directly with income:

 This option is incorrect because the Fisher equation of exchange does not directly relate the price level (P) to income. In the Fisher equation of exchange, changes in income do not directly affect the price level of the economy, even though they can influence the number of transactions (T).

c. P and M are constants:

This option is incorrect because the Fisher equation explicitly states that P and M are not constants. According to the equation, the money supply (M) and the velocity of money (V) are equal to the price level (P) and transaction volume (T) if the money supply (M) and the velocity of money (V) are both constants. The velocity of money and the volume of transactions are not constants, so P and M can also not be constants.

d. None of the above:

 This option is incorrect because option (b) is the correct answer. Through the equation MV = PT, the Fisher equation of exchange establishes a direct relationship between the money supply (M) and the price level (P).

The Fisher equation of exchange is an integral part of monetary theory and plays an important role in explaining the relationship between the money supply, the velocity of money, the price level, and overall economic activity.

Conclusion

The Fisher equation of exchange establishes a direct relationship between money supply (M) and price level (P) in an economy. Therefore, the correct answer is (b). Inflation typically occurs when the money supply increases, whereas price levels tend to rise as the money supply increases. A fundamental concept in monetary economics, this equation provides valuable insights into the factors influencing price changes.

While the Fisher equation of exchange highlights the relationship between M and P, real-world economies are much more complex, and other factors, such as changes in the velocity of money (V) and the volume of transactions (T), play an important role in determining price levels and overall economic activity.

The equation is therefore used by economists to analyze and understand the complexities of monetary policy, inflation, and economic stability along with other theories and models.

Equation of exchange is converted into the quantity theory of money by assuming the following variables as constants

Bibisha Shiwakoti

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