Quantity Theory of Money

The quantity theory of money explains the general price level by relating the stock of money to the volume of goods and services exchanged. It argues that, when the velocity of money and real output are stable, an increase in the money supply causes a proportionate increase in the general price level.

Core mechanism

The income form is MV = PY, where M is money supply, V is velocity of circulation, P is the general price level and Y is real output. Rearranging gives P = MV/Y: prices rise when nominal purchasing power increases faster than real output.

• If V and Y remain constant, a 10 per cent increase in M produces a 10 per cent increase in P.
• In growth-rate terms, inflation is approximately money-supply growth plus velocity growth minus real-output growth.
• Money is treated mainly as determining nominal variables, while real output is determined independently under the classical assumptions.

Fisher and Cambridge formulations

Fisher's transactions approach uses MV = PT, where T denotes the volume of transactions. The Cambridge cash-balance approach states M = kPY, where k is the fraction of nominal income people wish to hold as money.

• The Fisher approach emphasises money's use as a medium of exchange and its rate of circulation.
• The Cambridge approach emphasises the demand to hold money; if k and Y are stable, a larger M raises P proportionately.

Conditions and limitations

The strict proportional result depends on a stable velocity or cash-balance ratio and output that does not respond to monetary expansion. These conditions are more plausible as a long-run simplification than as a complete short-run account of inflation.

• With unemployed resources, higher money demand may initially increase output and employment, not merely prices.
• Financial innovation, interest rates and changing payment habits can alter velocity or the desired cash balance.
• Supply shocks can change prices through output and costs even without a corresponding change in money supply.