Money x Velocity = Price x Transactions
Money x Velocity = Price x Output
This theory seeks to explain how money affects the economy, and is based on the fact that money is demanded as a medium of exchange. We can say that price level is a function of the quantity of money in circulation. The transaction version of the quantity theory states that the changes in money supply other things remaining the same, brings a directly proportionate change in the price level. Other things remaining unchanged, as the quantity of money in circulation increases, the price level also increases in direct proportion and value of money decreases. What does the assumption of constant velocity imply?
When we make the assumption that the velocity of money is constant, then the equation becomes the quantity theory of money. The quantity equation can be seen as a theory of what determines nominal GDP (the level of prices). With MV = PY (where velocity is constant), then a change in the quantity of money M must cause a proportionate change in nominal income PY. That is, if velocity is fixed, then the quantity of money determines the nominal value of the economy’s output/GDP.
Suppose a country has a money demand function (M/P)^d = kY, where k is a constant parameter. The money supply grows by 12 percent per year, and real income grows by 4percent per year.
a. To ﬁnd the average inﬂation rate the money demand function is %growth Md − %growth P = %growth Y
12% - 4% = 8%
b. Increase in real income growth will result in a lower average inflation rate. For example, if real income grows at 6% and money supply growth remains at 12%, then inflation falls to 6%. Here a larger money supply is required to support a higher level of GDP, which results in lower inflation.
c. 1/k = V
When people hold a larger percent of their income (large k), money changes hands infrequently, or V is small. When people hold smaller percent...