Money and Inflation
Quantity theory of money: Establishes the relationship between money supply (Ms) and prices (inflation). According to the quantity theory, money supply and inflation is positively correlated, i.e., as money supply goes up, prices go up. In order to have stable prices, the change in money supply should be at a steady rate.
Diagram: Quantity theory of money: In reality, amongst the world economies we find that the pronouncements of the quantity theory do hold true. Countries with steady growth of money supply (USA) have had a low increase in prices (low and steady inflation) over time over the last three decades. On the other hand countries with high growth rate of money supply (Argentina) have higher inflation rates. This was the prediction of the quantity theory of money.
Quantity theory of money: MV=PQ Where M= money supply V= velocity of circulation P=price level Q= real GDP (real output) The rest is easy except V needs an explanation. It is the average number of transactions done with a 1 dollar bill over a period of 1 year. So, if on average a 1 dollar bill does 10 transactions per year then the velocity of circulation is 10. In other words a 1 dollar bill does the equivalent of 10 dollars worth of transactions per year. Velocity of circulation in the USA is about 8. This quantity theory equation is an identity because it logically makes sense. The right hand side (RHS) = P х Q = Price (in dollars) times the output produced= GDP of the country. Assume it is 12 trillion dollars in the USA. Now to buy 12 trillion dollars worth of goods and services we need 12 trillion dollars. Therefore the left hand side (LHS) of the equation which is M х V has to be equivalent to 12 trillion dollars. Thus it is an identity equation. Now here V and Q are stable over time, and so can be assumed to be fixed. The real GDP (Q) of a country changes slowly and steadily over time because it is determined by the country's resources (financial, social, economic, natural, human etc.) These do not change dramatically, but slowly over time. Hence they are assumed to be stable. The velocity of circulation (V) is also stable since it is determined by factors such as the financial tools available in a country, like electronic banking facilities, ATM's, credit cards, wage payment methods (weekly, monthly etc.) and people's savings and spending habits (which also do not change dramatically over time). Thus it is also assumed to be stable. So in the equation: MV=PQ V and Q are stable and assumed fixed. Thus M is proportional to P, i.e., the price level changes proportionately to the change in money supply. M α P Therefore the rate of inflation will be proportionate to the rate of increase of the money supply. Thus inflation is a monetary phenomenon.
Real life evidence: There are many examples of countries with high money supply growth rates, and for all of them we have evidence of inflation following the spurt in the money supply.