Page 174 - DECO201_MACRO_ECONOMICS_ENGLISH

Unit 10: Theories of Inflation

10.2 The Quantity Theory of Money Notes

The quantity theory of money is one of the oldest theories in economics. Its basic prediction is
that there is a stable and proportional relationship between changes in the money supply and
the price level.
The theory is based on the equation of exchange. One way of expressing the equation of exchange
is
MV = PT
t
Where:
M is the money supply
V is the transactions velocity of money
t
P is the average price of each transaction
T is the total number of transactions made
The transaction velocity of money is the average number of times the money supply is used to
make a transaction.
The other way of expressing the equation is
MV = PY
y
Where:
V is the income velocity of money,
y
Y is real income, i.e., the total value of final output produced.
The average number of times the money supply is used to purchase final output is the income
velocity of money.

The income version is more useful than the transaction version since it avoids the problems of
double counting which would occur if we included all transactions, as well as the problem of
including transactions in goods produced in previous periods, which would occur if we included
transactions in second-hand goods.
MV is the total expenditure on final output in the economy over a given period of time.
y

Example: If the money supply is 5000 crores and, on an average, each unit of currency
is used four times in the purchase of final output, total expenditure on final output in this
economy is 20,000 cr.
P , is the value of final output produced in the economy, i.e., nominal GNP. By definition, this
y
must equal the value of total expenditure of final output. To say that MV = P simply tells that
y y
total expenditure is equal to total receipts.
However, it is said that V is not related to changes in the money supply and varies only slowly
y
over time. For simplicity, it is, therefore, sometimes treated as a constant. In addition, those
economists who accept this theory, called monetarists, argue that in the long run real income
does not vary with changes in the money supply. They argue that there is a natural rate of
output, which is determined by such factors as capital stock, technological progress, size of the
labour force and the skills it possesses, mobility of labour and so on. Again these factors are
likely to change only slowly over time and so the natural rate of output is usually assumed to be
constant in the long run.

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