Quantity Theory of Money
The Quantity Theory Theory states that there is a relationship between the money supply and the price level. It maintains that a rise in the money supply will lead to an equal rise in the level of prices in the economy. According to the theory, a 10% rise in the money supply would lead to a 10% rise in the price level. A rise in price level is tantamount to a rise in the inflation rate. It, therefore, implies that a rise in the money supply will increase the inflation rate. As more money is circulated in the economy, total spending (aggregate demand) rises, thereby causing inflation.
The theory is based on the Equation of Exchange, formulated by an American economist Irving Fisher. The equation, also known as the Fisher Equation is given below.
MV = PT
MV = PY
Where M = Money supply
V = Velocity of ciculation
P = General price level
T = Transactions in an economy
Y = Real GDP
The money supply (M) is the total amount of money going around the economy. This comprises cash in circulation and bank deposits. The velocity of circulation (V) shows the number of times each unit of money is passed from one person to another. The price level (P) measures the average prices of goods and services in the economy. Transactions (T) represent the total amount of goods and services in the economy. Real GDP is the total output of the economy. PY is the monetary value of the total output (nominal GDP).
The two sides of the equation are equal as they the left side (MV) represents total expenditure or AD in the economy while the right side (PT) represents the value of goods produced (PY). This means that the total spending in the economy must equal the value of the goods produced.
There is a group of economists that believes that there is a relationship between money supply and inflation. They assume that V and T are constant while a change in M will cause a change in P. A rise in the money supply would increase total spending in the economy (aggregate demand) and fuel inflation. These economists are known as monetarists.
Criticism of the Quantity Theory of Money
Keynesians opine that there is no relationship between M and P
Keynesians are a group of economists that believes in government intervention. They do not believe that controlling the money supply will control inflation like monetarists. They believe V is not constant and is inversely related to M. That is to say, if M increases, V decreases.