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:
- T is broadly equivalent to total output and is fixed in the short run
- 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).
- 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:
- V is not stable and responsive to interest rate changes.
- T is not fixed and is responsive to increases in the money supply below full employment.
- 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