Notes on Index Number and Fisher's Quantity Theory of Money | Grade 12 > Economics > Money | KULLABS.COM

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• Things to remember

### Index Number

An index number is a statistical tool which is used to measure the value of the money between two different years – the base year and the current year. It is a number which indicates the price level at any given time period compared with some standard year.

Mathematically,

Index Number = $$\frac{Current year price}{Base year price}$$

#### Steps of Calculating Index Number

1. Identifying the purpose:

It is the first step of constructing the index number. The purpose of the construction of index number should be identified at first before selection of the base year for the index number.

1. Selection of the base year:

Then the base year should be selected for the construction. There are two years in the table. One is a previous year and another is the present year. The base year represents the year on the basis of which change in price in other years is expressed.

1. Selection of commodities:

The commodities should be selected on the basis in which the index number is going to be constructed. The commodities should neither be very small nor so large.

1. Collection of price:

Collection of price is another stage of construction of index number.Retail price is the representative on the basis of consumer’s viewpoint. Retail price is not uniform. So the wholesale price is supposed to be appropriate.

1. Use of formula and getting the change in price level:

The average of the numbers for the base year is 100 every time. Deviation from the base year is shown by the current year. Several statistical measures can be used for calculation of the averages. They are; arithmetic mean, geometric mean, harmonic mean etc.

Constructing a Simple Index Number

The index number constructed by giving equal importance or weight to all commodities is called simple index number. While calculating simple index number, base year index number is assumed 100.

### Fisher’s Quantity Theory of Money

Fisher’s quantity theory of money was introduced by an American economist Irving Fisher, in his book ‘The purchasing power of money’ in 1911 A.D. This theory explains the relationship between money supply, price level, and the value of money.

This theory explains that there is direct and proportional relationship between money supply and general price level, but inverse relationship between money supply and the value of the money.

Statement

According to Fisher’s quantity theory of money, “Other things remaining the same, any given percentage increase or decrease in money supply leads to the same percentage increase or decrease in the price level of the commodity and the value of money changes inversely with the supply of money.”

Assumptions of the theory

• The price level is passive variable.
• The variables like M, V, P & T are independent.
• The total volume of the transaction (T) and velocity (V) are constant.
• There is the full employment of resources in the long run.
• This theory is based on the assumption of a long period.

In formula,

MV= PT

or, P= $$\frac{MV}{T}$$

Where,

M= Supply of money

V= Velocity of money or velocity of circulation

P= Price level

T= Total volume of transacted goods and services

#### Criticisms of Quantity Theory of Money

1. Price level not only influenced by the money supply:

According to the theory, price level depends on the money supply. But money also depends on other several factors such as income level, production cost, wage rate, etc.

1. Static theory:

The theory assumes that M, V, P and T are constant. But these factors are not independent. So this theory is the static theory.

1. Unrealistic assumption of long period and full employment:

This theory is based on the long run but the economy is also affected by the short run phenomenon. Also, the full employment in an economy is not possible in real world.

1. Interest rate is ignored:

The influence of the rate of interest on the price level is ignored in the theory. But interest rate influences the supply of bank money or the credit money.

1. One-sided theory:

Fisher’s theory only explains about the supply of money and its effects and assumes the demand for the money to be constant. The theory ignores the role of the demand for the money in causing the changes in the value of money. So it is a one-sided theory.

1. Ignores the store value of money:

Money is only considered as the medium of exchange but doesn’t explain the importance of money as a store of value. This theory ignores the store value of the money.

(Jha, Bhusal and Bista)(Karna, Khanal, and Chaulagain)

Bibliography

Jha, P.K., et al. Economics II. Kalimati, Kathmandu: Dreamland Publication, 2011.

Karna, Dr.Surendra Labh, Bhawani Prasad Khanal and Neelam Prasad Chaulagain. Economics. Kathmandu: Jupiter Publisher and Distributors Pvt. Ltd, 2070.

• Steps of constructing index number
1. Identifying the purpose
2. Selection of the base year
3. Selection of commodities
4. Collection of price
5. Use of formula and getting the change in price level
• An index number is a statistical tool which is used to measure the value of the money between two different years – the base year and the current year.

• Fisher’s quantity theory of money was introduced by an American economist Irving Fisher, in his book ‘The purchasing power of money’ in 1911 A.D.

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