Irving Fisher put forward a theory called the Quantity Theory of money, so the name is not Irving Fisher Theory, Irving Fisher is the name of the inventor of the theory, while the theory itself is called Quantity Theory of Money in English.
The quantity theory of money is a theory that states the relationship between variations in the price of money and variations in the amount of money in bear. So this theory argues that there is a mechanical proportional relationship between the price of goods and the level of goods in general, that is, changes in the level of money supply affect changes in the prices of goods on the market. The relationship between the money supply and the price of goods in the market is stated in the Fisher Equation, namely:
MxV=PxT
M is the money supply, V is the speed in circulation of money, P is the prevailing price level, while T is the trading volume.
From the above equation it can be concluded that this quantity theory suggests that an increase in the amount of money causes inflation, whereas a decrease in the amount of money circulating in the economy has an impact on deflation. For example, Bank Indonesia lowers interest rates, resulting in an increase in the money supply due to the additional supply of money by commercial banks to the economy through bank lending. As a result, there will be an increase in inflation in the long run. If Bank Indonesia wants to put a brake on inflation, they will usually lower interest rates.
It also contains the statement that people’s purchasing power is strongly influenced by the amount of money in circulation, the more money in circulation means the lower the people’s purchasing power. So even though the money supply in the economy is increasing, the people are not getting more prosperous, ironically, the additional supply of money to the economy is not enjoyed by the whole community, only some of them have access to this increased money supply.
The strength of Irving Fiseher’s Quantity Theory of Money is the simplicity of this theory. Consisting of only 4 variables, we can easily use this formula from Quantity Theory of Money. However, this theory has a weakness in the use of some false assumptions, which do not really happen in the real world, for example a proportional increase in the money supply which in reality is not the case, as well as assumptions about variable indence and price stability which are not true. really exist in the real world.
Irving Fisher, an American economist with the Fisher hypothesis, namely: the Fisher effect, the relationship between interest rates and inflation. In Fisher’s eyes, the two are bound together by various economic demands. This relationship is so strong that if inflation rises, interest rates will rise by the same amount.
Irving Fisher introduced the theory of the demand for money with the velocity approach. This approach explains that the money spent equals the money received. That is, the function of money here is only as a medium of exchange, Fisher also revealed that the demand for money is a very liquid interest for transaction motives
The Fisher effect is often used to understand the actual and nominal interest rates. One example of this would be considering a country’s inflation rate. If a country’s inflation rate increases by 1%, the Fisher effect states that interest rates will also rise by 1%.
Irving Fisher’s Theory
This theory holds that there is a direct relationship between the growth in the money supply and the increase in general prices. The quantity theory of money provides a clear framework for a systematic direct relationship between growth in the money supply and inflation.
The amount of money paid by the buyer must be equal to the money received by the seller in a certain period. The value of the goods sold is equal to the volume of transactions (T) times the average price of the goods (P). On the other hand, the value of the goods traded must be equal to the volume of money in the community (M) multiplied by the number of times the average money exchange or the average velocity of money in a certain period (Vt).
Weaknesses In Irving Fisher’s Theory
1. Payments made for purchases of goods in the past and purchases of goods whose payments were made at a later time. only if these two things neutralize each other then Fisher’s formula is recognized as true. So MV=PT, if Ev-Ee=O, where Ev is the payment for the purchase of goods in the previous moment, and Ee is the purchase of goods whose payment was made at a later time. So according to this opinion, if Fisher’s formula is changed to MV-EV+Ee=PT
2. In Fisher’s formula, it does not pay attention to payments that are only in the financial sector without being accompanied by an exchange of goods, such as securities trading, interest payments, taxes and insurance premiums. If the amount of these payments is for example Ef, then the correct formula is MV=PT+Ef, in fact the difference between this formula and Fisher’s formula lies in the difference in the definition of V. V in the Fisher formula = PT/M , while V in the MV formula = PT + Ef is ( PT+Ef)/M. V in MV=PT is the velocity of circulation of money or the trade velocity of money, while V in MV=PT+Ef is the velocity of circulation of transactions of money or the transaction velocity of money.
Irving Fisher argues that in an indirect economic relationship there is a binding correlation in the country’s economic sector between interest rates and inflation, this can happen where the two variables are directly related to economic conditions, please note that this relationship is very vulnerable to social conditions. the economy that occurs, where when there is a high demand for money it causes a monetary crisis because of the amount of money in circulation. This situation causes inflation to increase, then to reach the equilibrium point, interest rates are also indirectly directed to increase because this is related to liquidity in terms of transactional affairs.
The ratio applied by Irving Fisher by juxtaposing two things related to inflation and interest rates is also proportional, namely 1 to 1, every increase in inflation will definitely be followed by an increase in interest rates.
This theory has a view of the demand for money (money supply) with the condition that the price of goods is also the same. Basically there is not much difference because this framework shows general conditions with the hope of reaching the equilibrium point or the balance of monetary conditions.