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Economic Theory

4. Equation of Exchange of Money. Quantity Theory of Money
People hold money to buy goods and services. The more money they
need for such transactions, the more money they hold. Thus, the quantity
of money in the economy is related to the number of dollars exchanged in

transactions.
The quantity theory of money has been put forward in the form of an

equation known as the “Equation of Exchange”:

M V  P , Q (7.3)

where M – amount of money;
V – velocity of circulation of money;

P – price level;
Q – quantity of product.
Velocity of circulation (V) refers to the number of times that each unit
of money is used during a given period. The equation tells when the supply

of money increases, other things being equal, there will be a rise in the
price level. That means a fall in the value of money. For example, when
‘M’ is doubled, ’P’ will be doubled.

Yet if we make the additional assumption that the velocity of money is
constant, then the quantity equation becomes a useful theory about the
effects of money, called the quantity theory of money. As with many of
the assumptions in economics, the assumption of constant velocity is only

a simplification of reality. Velocity does change if the money demand
function changes.
With this assumption included, the quantity equation can be seen as a

theory of what determines nominal GDP. The quantity equation says:

M V  P , Q (7.4)

where the bar over V means that velocity is fixed. Therefore, a change in

the quantity of money (M) must cause a proportionate change in nominal
GDP (PY ). That is, if velocity is fixed, the quantity of money determines
the dollar value of the economy’s output.
This theory explains what happens when the central bank changes the

supply of money. Because velocity is fixed, any change in the money
supply leads to a proportionate change in nominal GDP. Because the
factors of production and the production function have already determined

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