The Quantity Theory of Money
The quantity theory of money proposes that the quantity of money and price levels increase at the same rate in the long run. This concept is demonstrated by the equation of exchange.

The Equation of Exchange
The equation of exchange is comprised of the money stock, M, multiplied by the velocity of money, V. The velocity of money is the number of times money turns over (spent as part of a final good or service) during the year.

Therefore, we get the expression:

Formula 4.4

M × V= P × Q = Total Spending or GDP

P represents the price level, and Q represents the quantity of goods and services produced. This equation is referred to as the equation of exchange. It is the basic equation used by monetarists - economists who believe that fluctuations in the money supply are the chief source of fluctuations in real economic output and that the major cause of inflation is excessive growth in the money supply.

If quantity and velocity are basically constants, increasing the money supply will just lead to an increase in prices (inflation). The Quantity Theory of Money holds that in the long run, because quantity and velocity are not changed by the money supply, a percentage increase in the money supply will lead to a corresponding increase in the price level. However, if monetary policy can influence velocity or quantity, monetary policy can be useful.

The equation of exchange can be converted into the demand for money function:

Formula 4.5

Md = (P × Q) / V = Y / V

Where Md is the demand for money and Y is nominal GDP. From the monetarist's viewpoint, the demand for money is related to nominal GDP, not interest rates (the Keynesian viewpoint).

Inflation

Related Articles
  1. Insights

    What is the Quantity Theory of Money?

    Take a look at the tenets, assumptions and challenges of monetarism's principal theory.
  2. Trading

    The Printing Money Causes Inflation Theory

    The Quantity Theory of Money states there is a direct relationship between the quantity of money in an economy and the prices of goods and services.
  3. Insights

    Explaining Quantity Demanded

    Quantity demanded describes the total amount of goods or services that consumers demand at any given point in time.
  4. Trading

    What's the Velocity of Money?

    The velocity of money measures the rate at which money goes from one transaction to another in an economy.
  5. Investing

    How Much Debt Is Too Much? Examples From Around the World

    Unearth the facts surrounding the growing debt within the U.S., China, Japan and the Eurozone, and discover how these debt levels have diminished productivity.
  6. Insights

    Inflation for Dummies

    Inflation may seem like a straightforward concept, but it is more complex than it appears. We examine its varieties and causes.
  7. Insights

    Monetarism: Printing Money To Curb Inflation

    Learn how Milton Friedman's monetarist views shaped economic policy after World War II.
Frequently Asked Questions
  1. What are Some Advantages of Raising Capital Through Private Placement?

    Understand how a business can raise capital through private placement and the benefits business owners receive through this ...
  2. A Hostile Takeover vs. Friendly Takeover

    Learn about the difference between a hostile takeover and a friendly takeover, and understand how proxy fights and tender ...
  3. What Level of Return on Equity is Common for Bank?

    Discover what the average return on equity (ROE) ratio is for companies in the banking industry, and understand the significance ...
  4. How is Warren Buffett Plan Bequeathing his Estate?

    Find out how much Warren Buffett is leaving for his heirs and how he wants the funds invested after his death. Learn about ...
Trading Center