Quantity theory of money

Example

For example, if M represents Central Bank notes (for example, green paper U.S. dollars) then Q is the quantity of goods or assets bought with Central Bank notes. If M represents Central Bank notes plus checking account balances, then Q represents the quantity of goods or assets bought with paper or checking account balances. Textbooks carelessly define Q (or "Y") as the total quantity of goods produced in the economy (i.e., real gross domestic product). But this can lead to serious errors. For example, if only 30% of goods are bought with paper or checking account balances, and if the quantity of this type of money doubled, then it might happen that the quantity of goods bought with paper or checking account balances would double from 30% to 60%, while real output of goods (and P and V) are unaffected. Besides money can be used to buy goods produced in another time period (especially assets).

The left-hand side of the equation above equals the total amount of money spent during the month. The right-hand side equals the amount of money received.

Given this identity, the velocity of money can be measured as

    V =  (P .Q) / M

In an early work espousing the quantity theory, velocity is defined as 'the ratio of net national product in current prices to the money stock.'1

Historically, the main rival of the quantity theory has been the real bills doctrine, which says that the value of money is determined by the assets and liabilities of the money-issuing entity, rather than by the ratio of money to real GDP.

Principles

The theory is based on the following principles:

   1. The source of inflation is always, fundamentally, derived from the money supply.

   2. The demand for money is a function of wealth, the rate of return and the value of liquidity.

   3. Money demand is stable in the short run.

   4. The long run is what matters most; injection effects are not that important.

   5. The real rate of interest is determined by non-monetary factors (productivity of capital, time preference).

   6. The supply of money is usually exogenous.

   7. Money demand determines the real money supply.

   8. The purchasing power parity doesn't matter for money effects.

Inflation

The equation of exchange can be used as a rudimentary theory of inflation. If the velocity of money is given by financial institutions (such as the role of bank accounts and credit cards) and the amount of production is always at a fixed level (say, at full employment), then any increase in the amount of money leads to rising prices for the economy as a whole, i.e., inflation.

If V and Q are constant, then we can state the equation of exchange in terms of rates of growth: The rate of growth of the money supply = the inflation rate

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