Question

Inflation is frequently described as “too much money chasing too few goods.” Explain the cause of inflation using the quantity theory of money.

Answer 1

The quantity theory of money says that there is a positive relationship between money supply and price level i.e.,if money supply increases, the prices will also increase. A rapid increase in the money supply above the amount of output available in the economy will cause a rise in prices. If the quantity of money in the economy increases, price level will also increase and the value of money decreases. This relation is put forwarded by an American Economist Irving Fisher.

He explains the quantity theory by using an equation known as equation of exchange

MV = PT, where 'M' is the quantity of money, 'V' is the velocity of circulation i.e., the number of times a unit of money changes hands in a year, 'P' is the price level and 'T' is the transactions. The right hand side of the quation shows the demand for money(PT) and the left hand side is the supply of money(MV). The price level can be calculated by P = MV/T

The theory states that in the short run both the Velocity of circulation (V) and total transactions (T) remains constatnt. Therefore any changes in the quantity of money will cause changes in the price level. This can be illustrated by an example

Suppose that the total quantity of output is 200 units and the quantity of money in the economy is 2500 and the velociy of money is 4. The total value of transaction is 10000 (2500 X 4 = 10000). The price of one unit of output will be 10000/200 = 50 per unit. If the government increases the quantity of money to 5000 without any change in the level of output and velocity then the total value of transaction will be 20000 (5000 X 4 = 20000). The price of out put will rises to 20000/ 200 = 100 per unit of output.

From the above illustration we can see that without any change in the level of output and velocity of money, an increase in the quantity of money in the economy will cause the prices to rise. As the quantity of money doubles the price level also doubles.