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By Jodi Beggs
Introduction to Quantity Theory
The relationship between the supply of money and
inflation, as well as deflation, is an important concept in economics.
The quantity theory of money is a concept that can
explain this connection, stating that there is a direct relationship between
the supply of money in an economy and the price level of products sold.
What Is the Quantity Theory of Money?
The quantity theory of money is the idea that the
supply of money in an economy determines the level of prices, and changes in
the money supply result in proportional changes in prices.
In other words, the quantity theory of money states
that a given percentage change in the money supply results in an equivalent
level of inflation or deflation.
This concept is usually introduced via an equation
relating money and prices to other economic variables.
The Quantity Equation and Levels Form
· M represents the amount of money available in an
economy; the money supply
· V is the velocity of money, which is how many times
within a given period, on average, a unit of currency gets exchanged for goods
and services
· P is the overall price level in an economy (measured,
for example, by the GDP deflator)
· Y is the level of real output in an economy (usually
referred to as real GDP)
The right side of the equation represents the total
dollar (or other currency) value of output in an economy (known as nominal
GDP).
Since this output is purchased using money, it stands
to reason that the dollar value of output has to equal the amount of currency
available times how often that currency changes hands.
This is exactly what this quantity equation states.
This form of the quantity equation is referred to as
the "levels form" since it relates the level of money supply to the
level of prices and other variables.
A Quantity Equation Example
Let's consider a very simple economy where 600 units
of output are produced and each unit of output sells for $30.
This economy generates 600 x $30 = $18,000 of output,
as shown in the right-hand side of the equation.
Now suppose that this economy has a money supply of
$9,000.
If it is using $9,000 of currency to purchase $18,000
of output, then each dollar has to change hands twice on average.
This is what the left-hand side of the equation
represents.
In general, it's possible to solve for any one of the
variables in the equation as long as the other 3 quantities are given, it just
takes a bit of algebra.
Growth Rates Form
The quantity equation can also be written in
"growth rates form," as shown above.
Not surprisingly, the growth rates form of the
quantity equation relates changes in the amount of money available in an
economy and changes in the velocity of money to changes in the price level and
changes in output.
This equation follows directly from the levels form of
the quantity equation using some basic math.
If 2 quantities are always equal, as in the levels
form of the equation, then the growth rates of the quantities must be equal.
In addition, the percentage growth rate of the product
of 2 quantities is equal to the sum of the percentage growth rates of the
individual quantities.
Velocity of Money
The quantity theory of money holds if the growth rate
of the money supply is the same as the growth rate in prices, which will be
true if there is no change in the velocity of money or in real output when the
money supply changes.
Historical evidence shows that the velocity of money
is pretty constant over time, so it's reasonable to believe that changes in the
velocity of money are in fact equal to zero.
Long-Run and Short Run Effects on Real Output
The effect of money on real output, however, is a bit
less clear.
Most economists agree that, in the long run, the level
of goods and services produced in an economy depends primarily on the factors
of production (labor, capital, etc.) available and the level of technology
present rather than the amount of currency circulating, which implies that the
money supply cannot affect the real level of output in the long run.
When considering the short-run effects of a change in
the money supply, economists are a bit more divided on the issue.
Some think that changes in the money supply are
reflected solely in price changes rather quickly, and others believe that an
economy will temporarily change real output in response to a change in the
money supply.
This is because economists either believe that the
velocity of money is not constant in the short run or that prices are
"sticky" and don't immediately adjust to changes in the money supply.
Based on this discussion, it seems reasonable to take
the quantity theory of money, where a change in the money supply simply leads
to a corresponding change in prices with no effect on other quantities, as a
view of how the economy works in the long run, but it doesn't rule out the
possibility that monetary policy can have real effects on an economy in the
short run.
Jodi Beggs
Economics Expert
Education
Ph.D., Business Economics, Harvard
University
M.A., Economics, Harvard University
B.S., Massachusetts Institute of
Technology
Introduction
Economics instructor at Harvard
University and Northeastern University
Economics and data science consultant and
subject-matter expert
Experience
Jodi Beggs, Ph.D., is an economist
and data scientist. She has been an economics instructor at Harvard since 2004,
teaching courses within Harvard College, the Harvard Kennedy School of
Government, and Harvard Extension School. Previously, she was a lecturer
at Northeastern University, where she taught undergraduate and graduate
courses in macroeconomic theory and behavioral economics.
Dr. Beggs has produced educational
materials for textbook publishers including Cengage Learning and W.W.
Norton. She is also a subject-matter expert for media outlets including
Reuters, BBC, and Slate. She regularly consults on economics and data science
projects, and she runs the site Economists Do It
With Models.
Education
Dr. Beggs earned a Ph.D. in Business
Economics and an M.A. in Economics from Harvard University. She
also received Master of Engineering and B.S. degrees from
M.I.T.
Awards & Publications
Harvard University Certificate of
Distinction in Teaching, 2004-05
TedXBoston, "Context is King"
(lecture)
Eta Kappa Nu Engineering Honor Society
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