Q:

How would you explain the quantity theory of money?

A:

Quick Answer

According to About.com, the quantity theory of money states that the supply of money in an economy determines the level of prices, and changes in the money supply result in proportional price changes. Therefore, a given percentage change in money supply results in an equivalent level of inflation or deflation.

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Full Answer

About.com states that the concept is typically introduced using an equation known as the levels form, which relates money and prices to other economic variables. In this equation, money supply multiplied by velocity of money is equal to the price levels multiplied by the levels of real output in an economy. The first part of the equation represents the total dollar (or other currency) value of output in an economy. Because the output is purchased using money, it stands to reason that the dollar value of output equals the amount of currency available multiplied by how often the currency changes hands.

According to the Economic Times, the theory is accepted by most economists. Keynesian economists and others from the monetarist school of economics have criticized the theory, claiming that it fails in the short run when the prices are sticky and because the velocity of money does not remain constant. Despite this, the theory is very well-respected and is used to control inflation in the market.

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