Question

Explain in words, intuitively, the Quantity Theory of Money (QTM). Subsequently, write down the QTM equation and discuss each variable in the equation separately. Discuss any empirical evidence supporting this theory.

Answer 1

The quantitative theory of money simply states that, in an economy, the money supply and price levels are in direct proportion to one another. When the money supply changes, there is a proportional change in price levels and when price level changes, the money supply changes by the same proportion.

Say, if the average price level is high and goods and services tend to cost a significant amount of money, consumers will demand more money and vice versa.

A simple example, the cost of butter in 2001 was $3, whereas the current cost of the same is $5. This is a result of inflation. And, one of the reasons for inflation is the change in money supply in the economy.

A decade ago when the average income of an individual was $1000/month, his expenditure would have been around $800/month excluding savings. In the current time period, both, the income and expenditure have gone up. This is due to the changes in the money supply in an economy.

Quantitative theory of money is the theory that links growth rates in the money supply to growth rates in the prices. Its equation is as follows:

                MV = PQ

MV represents what is bought in an economy which is the nominal GDP.

PQ represents what is sold which is also the nominal GDP.

Where,

M = money supply

V = velocity of circulation (the number of times a currency is spent in an economy)

P = average price level à inflation

Q = quantity of goods/services sold

By definition, what is sold must have been bought by somebody. What is bought by people must have been sold by producers. Therefore, MV has to be equal to PQ.

Take an example, an economy produces 2000 tonnes of butter, the money supply is $2500 and the velocity of circulation is 4. Now, substituting the above values in the equation MV = PQ we get, P = $5.

In the above values, now double the value of money supply in the economy to be $5000. Then, we get the price P = $10. Therefore, it is evident that when the quantity of money is altered, the prices in the economy will also be altered accordingly.