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SparkNotes:Money:Quantitytheoryofmoney

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Home SparkNotes Economics Study Guides Money Quantity theory of money

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MONEY

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Quantity theory of money

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Summary and
Analysis
Money
Problems
Quantity theory of
money

Value of money
What gives money value? We know that intrinsically, a dollar bill

Problems

is just worthless paper and ink. However, the purchasing power

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of a dollar bill is much greater than that of another piece of paper

Problems

of similar size. From where does this power originate?

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Like most things in economics, there is a market for money. The

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supply of money in the money market comes from the Fed. The

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Fed has the power to adjust the money supply by increasing or

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decreasing the number of bills in circulation. Nobody else can

make this policy decision. The demand for money in the money
market comes from consumers.
The determinants of money demand are innite. In general,
consumers need money to purchase goods and services. If
there is an ATM nearby or if credit cards are plentiful, consumers
may demand less money at a given time than they would if cash

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were dicult to obtain. The most important variable in

determining money demand is the average price level within the
economy. If the average price level is high and goods and
services tend to cost a signicant amount of money, consumers
will demand more money. If, on the other hand, the average price
level is low and goods and services tend to cost lile money,
consumers will demand less money.

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Figure %: Sample money market

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SparkNotes:Money:Quantitytheoryofmoney
The value of money is ultimately determined by the intersection
of the money supply, as controlled by the Fed, and money
demand, as created by consumers. Figure 1 depicts the money
market in a sample economy. The money supply curve is vertical

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because the Fed sets the amount of money available without

consideration for the value of money. The money demand curve
slopes downward because as the value of money decreases,
consumers are forced to carry more money to make purchases
because goods and services cost more money. Similarly, when
the value of money is high, consumers demand lile money
because goods and services can be purchased for low prices.
The intersection of the money supply curve and the money
demand curve shows both the equilibrium value of money as
well as the equilibrium price level.

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Figure %: Sample shi in the money market

The value of money, as revealed by the money market, is
variable. A change in money demand or a change in the money

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supply will yield a change in the value of money and in the price
level. Notice that the change in the value of money and the
change in the price level are of the same magnitude but in

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opposite directions. An increase in the money supply is

depicted in Figure 2. Notice that the new intersection of the
money supply curve and the money demand curve is at a lower
value of money but a higher price level. This happens because
more money is in circulation, so each bill becomes worth less. It
takes more bills to purchase goods and services, and thus the

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price level increases accordingly.

The quantity theory of money is based directly on the changes
brought about by an increase in the money supply. The quantity
theory of money states that the value of money is based on the
amount of money in the economy. Thus, according to the
quantity theory of money, when the Fed increases the money
supply, the value of money falls and the price level increases. In
the SparkNote on ination we learned that ination is dened as
an increase in the price level. Based on this denition, the
quantity theory of money also states that growth in the money
supply is the primary cause of ination.

Velocity
While the relationship between money supply, money demand,
the price level, and the value of money presented above is

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accurate, it is a bit simplistic. In the real world economy, these

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factors are not connected as neatly as the quantity theory of
money and the basic money market diagram present. Rather, a
number of variables mediate the eects of changes in the
money supply and money demand on the value of money and
the price level.
The most important variable that mediates the eects of
changes in the money supply is the velocity of money. Imagine
that you purchase a hamburger. The waiter then takes the money
that you spent and uses it to pay for his dry cleaning. The dry
cleaner then takes that money and pays to have his car washed.
This process continues until the bill is eventually taken out of
circulation. In many cases, bills are not removed from circulation

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until many decades of service. In the end, a single bill will have
facilitated many times its face value in purchases.
Velocity of money is dened simply as the rate at which money
changes hands. If velocity is high, money is changing hands

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quickly, and a relatively small money supply can fund a relatively

large amount of purchases. On the other hand, if velocity is low,
then money is changing hands slowly, and it takes a much larger
money supply to fund the same number of purchases.

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As you might expect, the velocity of money is not constant.

Instead, velocity changes as consumers' preferences change. It
also changes as the value of money and the price level change.
If the value of money is low, then the price level is high, and a
larger number of bills must be used to fund purchases. Given a
constant money supply, the velocity of money must increase to

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fund all of these purchases. Similarly, when the money supply

shis due to Fed policy, velocity can change. This change makes
the value of money and the price level remain constant.
The relationship between velocity, the money supply, the price
level, and output is represented by the equation M * V = P * Y
where M is the money supply, V is the velocity, P is the price
level, and Y is the quantity of output. P * Y, the price level
multiplied by the quantity of output, gives the nominal GDP. This
equation can thus be rearranged as V = (nominal GDP) / M.
Conceptually, this equation means that for a given level of
nominal GDP, a smaller money supply will result in money
needing to change hands more quickly to facilitate the total
purchases, which causes increased velocity.
The equation for the velocity of money, while useful in its original
form, can be converted to a percentage change formula for
easier calculations. In this case, the equation becomes (percent
change in the money supply) + (percent change in velocity) =
(percent change in the price level) + (percent change in output).
The percentage change formula aids calculations that involve
this equation by ensuring that all variables are in common units.
The velocity equation can be used to nd the eects that
changes in velocity, price level, or money supply have on each
other. When making these calculations, remember that in the
short run, output (Y), is xed, as time is required for the quantity

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of output to change.
Let's try an example. What is the eect of a 3% increase in the
money supply on the price level, given that output and velocity
remain relatively constant? The equation used to solve this
problem is (percent change in the money supply) + (percent
change in velocity) = (percent change in the price level) +
(percent change in output). Substituting in the values from the
problem we get 3% + 0% = x% + 0%. In this case, a 3% increase
in the money supple results in a 3% increase in the price level.
Remember that a 3% increase in the price level means that
ination was 3%.
In the long run, the equation for velocity becomes even more
useful. In fact, the equation shows that increases in the money
supply by the Fed tend to cause increases in the price level and
therefore ination, even though the eects of the Fed's policy is
slightly dampened by changes in velocity. This results a number
of factors. First, in the long run, velocity, V, is relatively constant
because people's spending habits are not quick to change.
Similarly, the quantity of output, Y, is not aected by the actions
of the Fed since it is based on the amount of production, not the
value of the stu produced. This means that the percent change
in the money supply equals the percent change in the price level
since the percent change in velocity and percent change in
output are both equal to zero. Thus, we see how an increase in
the money supply by the Fed causes ination.
Let's try another example. What is the eect of a 5% increase in
the money supply on ination? Again, we being by using the
equation (percent change in the money supply) + (percent
change in velocity) = (percent change in the price level) +
(percent change in output). Remember that in the long run,
output not aected by the Fed's actions and velocity remains
relatively constant. Thus, the equation becomes 5% + 0% = x% +
0%. In this case, a 5% increase in the money supply results in a
5% increase in ination.
The velocity of money equation represents the heart of the
quantity theory of money. By understanding how velocity
mitigates the actions of the Fed in the long run and in the short
run, we can gain a thorough understanding of the value of
money and ination.

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