Tag Archives: Quantity Theory of Money

A2 Economics – Quantity Theory of Money

Just covered MV = PT with my A2 class and produced some notes followed by a video from Marginal Revolution which I got from the Economics Teacher group.

Quantity Theory of Money

The Monetarist explanation of inflation operates through the Fisher equation.

M x V = P x T

M = Stock of money

V = Income Velocity of Circulation

P = Average Price level

T = Volume of Transactions or Output

For example if M=100 V=5 P=2 T=250.   Therefore MV=PT – 100×5 = 2×250

Both M x V and P x T are equivalent to TOTAL EXPENDITURE or NOMINAL INCOME in a given time period. The Quantity Theory is the familiar monetarist interpretation of the Equation and is based on the following assumptions:

  1. T is broadly equivalent to total output and is fixed in the short run
  2. V is broadly stable (i.e. the demand to hold money is relatively uninfluenced by the change in interest rates that arises from changes in the money stock).
  3. Causality runs from the left hand side to the right hand side of the equation

On these assumptions, increases in the money supply (after a suitable time lag) cause equivalent increases in the price level.

Critics argue that:

  1. V is not stable and responsive to interest rate changes.
  2. T is not fixed and is responsive to increases in the money supply below full employment.
  3. Change is P tend to cause changes in M (and not v.v.). In other words, changes in the money supply accommodate inflation and do not cause it.

Calculation using MV = PT

Since MV=PT (by definition), if M=$60, V=4 and T=12, then P can be found.

P =   MV /T  =  (60 x 4)/12  =  $20