Quantity Theory of Money

The quantity theory of money is an important tool for thinking about issues in macroeconomics.

The equation for the quantity theory of money is: M x V = P x Y

What do the variables represent?

M is fairly straightforward – it’s the money supply in an economy.

A typical dollar bill can go on a long journey during the course of a single year. It can be spent in exchange for goods and services numerous times. In the quantity theory of money, how many times an average dollar is exchanged is its velocity, or V.

The price level of goods and services in an economy is represented by P.

Finally, Y is all of the finished goods and services sold in an economy – aka real GDP. When you multiply P x Y, the result is nominal GDP.

Actually, when you multiply M x V (the money supply times the velocity of money), you also get nominal GDP. M x V is equal to P x Y by definition – it’s an identity equation.

You can think about the two sides of the equation like this: the left (M x V) covers the actions of consumers while the right (P x Y) covers the actions of producers. Since everything that is sold is bought by someone, these two sides will remain equal.

Up next, we’ll use the quantity theory of money to discuss the causes of inflation.

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