Question

8) Write the quantity equation for money. What does V stand for? What assumption do monetarists make about it? What is the resulting recommendation for monetary policy.

Answer 1

1. Quantity equation of money:

MV = PT

where M = money supply,
2. V = velocity of money
P = price level
T = volume of transactions

3. It is based on several assumptions - ceteris paribus. The theory fails in the short run, when prices are sticky. Velocity of money doesn't remain constant over time, yet it is assumed to be constant, and is not affected by any factors. And the time period is assumed to be long to deal with sticky prices. Further, the volume over time is assumed to be constant. Price is assumed to be a passive factor and is affected by other factors but does not affect or cause changes itself. The economic system is monetized and all transactions take place through money alone.

4. The assumptions are unreal (like the full employment of resources and stable expenditure). The quantity of money in existence is a dominant influence on the price level in an average period, but it may not control the movements of prices. The effect on prices depends on whether changes in the quantity of money are offset by changes in the velocity. Variables used in the equation are not necessarily independent.

Value and money go hand in hand and thus the two theories must not be divided. Theory of prices should not remain isolated from the theory of output, employment, and money.

Hope this helped!