This theory assumes that the fundamental determinant of the price level is the quantity of money. In actual practice other things keep on changing in the short period as well as in the long period.
1. Unrealistic Assumption:
(a) In actual practice, the volume of Transactions (T) is subject to large changes over long periods of time. The rapid expansion of output in some special situations like emergency or recovery demonstrates that a considerable change in transactions may occur even during a relatively short period.
The volume of transactions effected with money depends not only on the current production but also upon the volume of money supply available for these transactions. T may be assumed as constant at full employment level, but this is also an unrealistic assumption.
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(b) The assumption that V may he regarded as constant is not also realistic. It has been experienced that changes in the velocity of money is of greater importance than changes in the quantity of money. For example, the cause of hyperinflation in Germany in 1923 was not so much due to the increase in M but due to the increase in V for everyone tried to spend a rapidly depreciating mark as quickly as possible.
(c) Fisher takes for granted a fixed relationship between M and M1. But it is not proved by experience that there is a proportional relationship between M and M1.
There are a number of times when M and M1 have moved in opposite directions. For example, during the Great Depression, deposits in the U.S.A fell by 35 per cent from 1929 to 1933 while currency rose by 30 per cent.
(d) The price level (P) far from being entirely passive, may contribute to changes in other factors. Because rising prices give profit incentives to business expansion, a rise in P tends to raise T which may cause an increase in the quantity of money and its velocity of circulation.
2. There are inactive balances:
Uner Fisher’s formula, the price level depends upon the total quantity of money. But it is only a part of the total quantity of money which influences prices. There always exist inactive balances which exert no pressure on the prices of goods and services. This is clearly seen during depression.
3. Fisher’s equation of exchange
G. Halm has pointed out an important inconsistency in Fisher’s equation of exchange. We have to note that M refers to a point of time. Whereas V refers to a period of time. Therefore the expression MV would involve the inconsistency of multiplying non-comparable factors unless the assumption is made that M is the same amount during the whole period.
4. It is wrong to assume always that increased spending does not raise the real output but raise prices only. If the increased spending occurs during a depression, when there is mass unemployment, output is apt to expand substantially without much increase in price.
Once we recognise that V and output are not constant even in the short run, the quantity theory is severely qualified. Spending (MV) may not rise in proportion to M because V falls. Prices may not rise in proportion to spending because output rises.
The theory thus holds good only under conditions of full employment when the supply of output becomes perfectly inelastic.
But if there is no full employment and if there are unemployed resources, changes in M are likely to produce changes both in money income and real income. When M is increased it is likely that P will not rise because output increases.
So long as there is unemployment, employment and output will increase with money supply. When there is full employment prices rise with increased money supply. But there may be some increase in the price level even before full employment if bottlenecks develop in the production of goods.
5. Prices may change and the value of money may vary for reasons entirely unconnected with the quantity of money.
Some examples are given below: (i) Changes in the level of efficiency wages may change costs of production and affect prices, (ii) If increase of output occurs under conditions of diminishing returns marginal costs will rise and prices will rise.
Similarly prices will fall if production increases under conditions of increasing returns, (iii) Increase and decrease of monopoly power will respectively increase and decrease prices.
6. The Quantity Theory is defective because it fails to explain the process by which changes in the amount of money affect the price level.
7. According to Crowther, the Quantity Theory puts a misleading emphasis on the importance of the quantity of money as the cause of price changes and pays too much attention on the level of prices.
But these principles in the Quantity Theory are not in accord with facts, changes in money supply and price level depends upon some more fundamental factors such as income, expenditure, saving and investment. The quantity of money is a secondary factor compared with the volume of expenditure.