Question

how the rate of inflation is determined by the rate of money growth? explain with the help of quantity theory of money.

Answer 1

Quantity theory of money (QTM) refers to the proposition that changes in the quantity of money (money supply) will have an approximate equal effect on the general price levels (inflation). Here the proposition of QTM looks like

Money Supply * Velocity of money (average number of transactions that money perform) = Price * Final Output (GDP)

In variables it is equal to => MV = PY, all variables are written respectively.

Let's rewrite this equation down in the form of change in variables.

Change in M * Change in Money Velocity = Change in Price * Change in GDP

Usually change in money velocity remains constant as it needs long time period to get change and assuming GDP will not change in the short term. So we can safely remove V & Y from equation considering them as fixed. Therefore we will get:

Change in M = Change in P

which means that if we change money supply this will have a direct effect on price levels (inflation) in a country. As we know that money supply can be changed within a short term frame this can lead to spike in inflation levels abruptly.

Therefore we can say that change in money supply determines the rate of inflation in a country.

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