Quantity Theory of Money and its Relevance

Generally, quantity theory of money asserts that nominal income is determined by the growth of the money supply and it is represented by the following equation:

i)Money Supply * Velocity of Circulation = Price Level * Output

It assumes that the velocity of circulation of money is relatively stable over time and that the economy is in full employment. So, any increase in money supply will lead to a rise in nominal income. Since the output is relatively constant, the growth in money supply determines the inflation rate in the economy.

It is also called the theory of demand for money because it explains how much money people hold for a given aggregate income. It is then represented in the following form:

ii)M^d = k*(PY) where k=1/V

Quantity theory says that money variables are neutral in the long run. Any increase in money supply will only have effect on the price level of the economy. So, a 5% increase in money supply will lead to a 5% increase in inflation rate assuming the velocity of circulation to be fairly constant. The data available tend to support the positive relation between money growth and inflation in the longer periods (Dwyer, Hafer ).

This theory suggests that fed can keep the inflation low and stable by keeping money supply low and stable. However, this direct relationship between money supply and inflation has faced several criticisms.

Velocity of circulation is found to be volatile. For instance, the percentage change in M1 velocity of circulation from 1981-1982 was 2.5%( Mishkin, 2004). Additionally, in periods of inflation, people expect prices to go up and the velocity of circulation increases. Moreover, in periods of depression, velocity declines sharply.

Similarly, the money demand version of the quantity theory assumes that interest rates do not affect the demand for money. However, demand for money is found to have been sensitive to interest rates.

Despite all the reservations, increase in money supply tends to increase inflation and this has been supported by various researches. Quantity theory may not be perfect, but it does give a lot of insight into the money supply and inflation behavior.