In Fisher’s transaction velocity model, which one of the following is not an assumption
- Velocity of circulation of money is constant
- The volume of transaction is constant
- Full employment
- P is considered as an active factor
Correct Answer: P is considered as an active factor
Answer Explanation
In Fisher’s transaction velocity model, the assumption that P (price level) is considered an active factor is incorrect. Assuming that P remains constant, there is no inflation or deflation in the model. By making this assumption, the model is simplified and the velocity of circulation can be directly related to the quantity of money.
Fisher’s transaction velocity model makes the following assumptions:
i. Velocity of circulation of money is constant:
Assuming money circulates at a constant rate over time, each unit of money is used the same number of times for transactions within a given period of time.
ii. The volume of transaction is constant:
It assumes that the volume of transactions remains constant. This means that the number of goods and services exchanged in the economy remains unchanged during the time period.
iii. Full employment:
This assumption simplifies the analysis of the relationship between money, prices, and transactions by assuming that all available resources are fully utilized in the economy.
Correct option (d) implies that price level (P) is considered an active factor in the model, which is not the case. According to Fisher’s transaction velocity model, the price level remains constant, and any changes in money or transaction volume are expected to affect the velocity of money as well.
Why the other options are not correct
a. Velocity of circulation of money is constant:
According to the assumption of constant velocity of circulation, money circulates within an economy at a fixed rate. Each unit of money is assumed to be used for the same number of transactions within a particular time period. In reality, however, the velocity of money fluctuates due to a variety of factors, including consumer confidence, interest rates, technological advancements, and economic conditions.
In the real world, the velocity of money tends to vary over time. For example, during economic expansion and confidence, people may spend more quickly, resulting in a higher velocity of money. Conversely, during economic downturns or uncertain times, people may hoard money, resulting in a lower velocity of money.
It is true that assuming constant velocity simplifies the model, but it does not adequately capture the complexities and fluctuations observed in real-world economies.
b. The volume of transaction is constant
A constant volume of transactions is assumed in Fisher’s transaction velocity model, meaning that the total number of goods and services exchanged in the economy remains constant over time. Using this assumption, we can construct a more straightforward relationship between money quantity, price level, and velocity.
There are a number of factors that can affect the volume of transactions, including changes in economic activity, changes in consumer spending patterns, fluctuations in business investments, and others. As a result of increased consumer spending during holidays or special events, the volume of transactions tends to increase. While consumers may reduce their spending during economic recessions or downturns, the volume of transactions may decrease.
A constant volume of transactions overlooks the dynamic nature of economic activity and may not accurately reflect real-world conditions.
c. Full employment
According to Fisher’s transaction velocity model, all available resources in the economy are fully utilized. This assumption simplifies the analysis and creates a direct relationship between prices, money, and transactions.
An economic challenge of achieving and maintaining full employment is complex. As a result of business cycles, technological advances, changes in government policies, and other factors, economies often experience fluctuations in employment levels. There is an increase in unemployment during economic downturns, and a decrease in unemployment during economic growth.
Assuming full employment, the model does not consider the potential impact of unemployment on the velocity of money and overall economic dynamics.
Conclusion
In Fisher’s transaction velocity model, the assumption of constant velocity of money, constant volume of transactions, and full employment simplifies the analysis and facilitates a direct relationship between money, prices, and transactions.
While these assumptions are accurate, they fail to fully capture the complexities and fluctuations observed in real-world economies, where money velocity, transaction volumes, and employment levels are dynamic. Simplicity makes the model useful for theoretical analysis, but it has limitations when applied to real-world economic situations.