Question

Explain the quantity theory of money. According to the quantity theory of money, if the price level is 120 with a money supply of 40 what will the price level be if the money supply increases to 50?

Answer 1

Quantity Equation is given by: MV = PY

M = Money Supply . V= Velocity of Money , P = Price Level and and Y = Real Output(or Real GDP)

According to Quantity Theory of Money, Velocity of Money is assumed to Be constant and hence because of this Quantity of Money determines PY(i.e. Nominal GDP). Also, According to them as Y is determined by factors of production, it is also assumed to be constant until and unless there is increase in factors of Production and because of this Change in Money Supply effects Price Level only(Change in Money supply does not effect Real GDP).

Formula:
% change in (AB) = % change in A + % change in B

Now MV = PY

=> % change in (MV) = % change in (PY)

=> % change in M + % change in V = % change in P + % change in Y

Now according to quantity theory V is constant and Y is determined by Factors of production and hence is also assumed to be constant

Hence % change in V = 0 and % change in Y = 0

Hence, % change in Money supply = % change in Price Level ---------------------------(1)

Hence According to quantity theory of money, change in Money supply affects Price level and hence If Money supply increases then Price will increase and hence There will be a inflation and vice versa.

Now here Money supply increases from 40 to 50.

Hence % change in Money supply = ((50 - 4)/40)*100 = 25 Hence Money Supply increases by 25%

According to quantity theory of Money (1) that , % change in Money supply = % change in Price Level

=> 25% = % change in Price Level

Hence Price level increased by 25%

Hence New Price level = 120 + (25/100)*120 = 150.

Hence, if the money supply is 50 then Price level will be 150