Download AP Macro The Quantity Theory of Money

AP Macro
The Quantity Theory of Money
The quantity theory of money is based directly on the changes brought about by an increase in the money supply. The
quantity theory of money states that the value of money is based on the amount of money in the economy. Thus, according to
the quantity theory of money, when the Fed increases the money supply, the value of money falls and the price level
increases.
This dynamic relationship is represented by the formula: MV = PQ
M = Money Supply or M1
V = Velocity
Velocity of money is defined simply as the rate at which money changes hands. If velocity is high, money is changing
hands quickly, and a relatively small money supply can fund a relatively large amount of purchases. On the other hand, if
velocity is low, then money is changing hands slowly, and it takes a much larger money supply to fund the same number
of purchases.
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The velocity of circulation "V" is defined as the average number of times a dollar bill circulates in the economy per year.
Assume on average a dollar bill does ten transactions (buying and selling of goods and services) per year.
Thus velocity of circulation "V" in this case is 10. Here, a one dollar bill does the equivalent of ten dollars’ worth of
transactions.
So, M x V=1x10=10 dollars
P = Price Level
Q = Output or Real GDP
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So, P x Q = nominal GDP
What would or should happen to the economy if any of these components changes?
The equation suggests that if V is constant and M is increasing, there must be an increase in either Q or P. Accordingly, monetary policymakers can
control inflation by allowing the money supply (M) to grow no faster than the desired rate of economic growth (Q).
1.
M V = P Q
bc…
2.
M V = P Q
bc…
3.
M V = P Q
bc…
4.
M V = P Q
bc…
If you’re confused, go here. This is a nice “proof” of the thought-process behind the Quantity Theory of Money.
http://www.econmentor.com/college-macro/associated-macroeconomic-topics/money/equation-of-exchange-mv=pq--quantity-theory-ofmoney/text/362.html#Equation of Exchange (MV=PQ) / Quantity Theory of Money