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Irving Fisher spent most of his adult life as a professor of economics at Yale University. An accomplished mathematician, he used those skills to explain many of his theories. In his best known formulation, the equation of exchange, Professor Fisher showed the relationship between the quantity of money in circulation and the level of prices.
The equation of exchange is stated as follows:
MV = PQ, where:
M = money supply
V = velocity of circulation
P = average price of goods and services
Q = quantity of units sold
Simply stated, the equation of exchange tells us that total spending is equal to the total value of the goods and services produce i by the economy. Let's see why. M is the total amount of money in circulation, and V is its velocity. Velocity is simply the number of times that money turns over in a year. In other words, the amount of money in circulation, multiplied by the number of times it is spent (MV) is equal to the total amount of money spent by the economy in the course of the year. To illustrate, let's suppose that each student in your class produced a product for sale, and that the selling price of each item is $1. Your teacher buys the product from the student sitting in the first row, first seat. That student uses the dollar to buy the product from the student in the second seat.
The process continues around the room as each student uses the dollar from the preceding student to buy the product of the next student. Assuming that there are 30- class members (including the teacher), 30 items will be sold. One dollar bill will be exchanged 30 times. Applying the equation of exchange, the total amount of money in circulation will be $30 because:
M = $1; V = 30; and MV - $1 x 30 = $30.
The equation of exchange helps to explain why prices (and therefore the value of money) fluctuate. Since MV = PQ, it follows that when V and Q are constant, any change in the money supply will directly affect prices. In other words, when the money supply increases, so will prices, and vice versa. We can also see that increases in the money supply will not result in price increases if the output of goods and services is increased at the same or a faster rate.
TEXT 19: KARL MARX (1818-1883)
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