Question

Define the quantity theory of money and show how it is related to the equation of exchange

Answer 1

Quantity theory of money will be reflecting a major branch of monetary economics which will be advocating that general price level for good and service in the economy is proportional to the money supply in an economy.

According to the quantity theory of money, the price level of goods and services is proportional to the money supply in economy and the amount of money in an economy will be doubling if so the price level will also be doubling and it will mean that consumer will be paying twice at similar to the amount he was paying earlier, so it will be increasing in inflation in the overall economy and inflation is measure for rising prices of various goods and services due to rising demands in the economy.

Forces that will be driving the supply and demand of money will be similar to the theory of demand and supply which will be reflecting that increase in the supply of money will be decreasing the marginal value of money and decrease in the supply of money will be increasing the marginal value of money.

In monetary economics the equation of exchange will be the relation of

M *V= P*Q

M=quantity of money, V=velocity of money, P= level of prices, T= sum of transaction over the period.

So it will be reflecting relation between the money side and the real side of economy and it will be showing that relationship between quantity of money and the price of money Eand we are assuming that velocity and sum of transactions are constant and increase in money will necessarily lead to increase in price so we will be believing in quantity theory of money.