The Fisher Equation: Quantity Theory of Money

                                          

Assume Y and V to be constant

Where    

            

           

          

This is one of the most abused formulas when used to analyze hyperinflationary economies. Although empirical evidence shows that the equation is consistent as a measure of a long-run relationship, in hyperinflationary economies it is applied in the short-run quite often. Those who push for this view opinion that excessive money supply growth causes inflation. I’m not saying that’s not true but what I’m saying is that it’s not the absolute growth in money supply which increases the price levels but considerations should be given to the marginal changes in the money supply.

This is because the role of expectations can’t be ignored and when you consider expectations in the mix, their effect are random, therefore changes in money supply don’t have linear effects towards the changes in the money supply levels. Therefore if you keep output and velocity constant, the equal sign doesn’t hold. For intuitive purposes the relationship can give us insights into the relationship between price and money supply but it isn’t robust enough for tractability purposes.

If you want to solve the problems of hyperinflation, surely this relationship shouldn’t be your basis for policy-making to contain short-run shocks and dislocations but should be used just for reference purposes only. Expectations are surely the best starting point. But this is a whole new area of analysis altogether. For long-run purpose it is still difficult to analyze because a hyperinflationary system is very dynamic such that the shocks are continuous enough such that we wouldn’t expect the system to return to a permanent equilibrium.

Despite the many occurrences of hyperinflationary episodes around the world over the course of modern history, the subject hasn’t been dealt with much depth and breadth it deserves.