The Quantity Theory of Money and the Fisher Effect

The Federal Reserve primarily adjusts the United States’ money supply by selling or purchasing government securities, such as treasury bills or bonds.  The Fed increases the money supply by purchasing securities from large banks and dealers, thus increasing the total amount of money in the economy.  Likewise, the Fed decreases the money supply by selling their share of government securities, taking money out of the economy.  According to the quantity theory of money, adjusting the money supply directly affects price levels in the long run.

The quantity equation states:

where

The velocity of money measures the rate at which money circulates in the economy.  Economists assume V is fixed, since people’s cash holding preference is relatively constant (the bar above V denotes that it is a fixed variable).  Output can be affected by interest rates in the short run according to the IS-LM Model, but Y is a function of labor and capital in the long run, so it is also fixed in this theory.  The above equation shows that if the Federal Reserve changes the money supply, price levels must adjust to maintain equilibrium.  So if M increases, P must increase, and if M decreases, P must decrease:

Since money supply has a direct effect on price levels, the central banks have ultimate control over whether or not their country experiences inflation.  The quantity equation highlights the direct relationship between changes in money supply and changes in price levels in an economy.  The Fisher Effect explains the direct relationship between changes in price levels and nominal interest rates.  The Fisher Equation states:

i = r + π

where

i = Nominal Interest Rates, r = Real Interest Rates, and π = Inflation Rate

This equation is intuitive since it simply states that the nominal interest rate is equal to the real interest rate plus the inflation rate.  However, the Fisher Effect shows an important one-to-one relationship between the inflation rate and the nominal interest rate once r is made constant, since real interest rates adjust to achieve equilibrium between savings and investment in the long run.  Graphing the inflation rate and nominal interest rate for the US over the past 46 years shows the strong correlation between these two variables:

The quantity theory of money shows that a percent change in money supply is met with an equal percent change in price levels, and the Fisher effect shows that a percent change in price levels causes an equal percent change in nominal interest rates.  It is important to note that these theories hold true for the economy in the long run, and may not be useful for short run economic analysis.