Question

The so-called quantity theory of money suggests that the amount of money in circulation is the primary determinant of the price level in the economy and that the growth rate of the money supply is the primary determinant of the inflation rate. Write a short essay evaluating the logic of these arguments.

Answer 1

The concept of the quantity theory of money (QTM) is age old. QTM states that there is a direct relationship between the quantity of money in an economy & the price level of goods & services sold. It states that if the amount of money in an economy doubles, price levels also double, causing inflation in the economy. Therefore, the consumer pays twice as much for the same amount of the good & service.

The QTM equation is as follows: -

MV = PT

Where:

M = Money Supply

V = Velocity of Circulation (the number of times money changes hands)

P = Average Price Level

T = Volume of Transactions of Goods & Services

And if we keep velocity and volume of transaction to be constant then Money supply is directly related to the price level.

And any growth in the money supply will let to increase in the price level and the inflation rate. Hence growth rate of money supply is primary determinant of the inflation. Which we can say consumer pay more than what he was paying initially for the same bundle of goods and services.