The theory of the quantity of money indicates that the money supply and the price level in an economy are in direct proportion to each other. When there is a change in the money supply, there is a proportional change in the price level and vice versa.
It is supported and calculated using the Fisher Equation on the theory of the quantity of money.
M * V = P * T
Where
M = Money supply
V = velocity of money
P = Price level
T = volume of transactions
The theory is accepted by most economists per se. However, Keynesian economists and economists from the Monetary School of Economics have criticized the theory.
According to them, the theory fails in the short term when prices are sticky. Furthermore, it has been shown that the velocity of money does not remain constant over time. Despite all this, the theory is highly respected and widely used to control inflation in the market.
The concept of the quantity theory of money (QTM) began in the 16th century. As the gold and silver inflows from the Americas to Europe were minted in coins, there was an increase in inflation. This led the economist Henry Thornton in 1802 to assume that more money equals more inflation and that an increase in the money supply does not necessarily mean an increase in economic output. Here we look at the assumptions and calculations underlying TQD, as well as its relationship to monetarism and the ways in which the theory has been challenged.
TQD, in a nutshell
The quantity theory of money indicates that there is a direct relationship between the quantity of money in an economy and the price level of the goods and services sold. According to TQD, if the amount of money in an economy doubles, price levels also double, causing inflation (the percentage rate at which the price level is increasing in an economy). Therefore, the consumer pays twice the same amount for the good or service.
Another way to understand this theory is to recognize that money is like any other commodity: increases in its supply decrease the marginal value (the purchasing power of a unit of currency). Thus, an increase in the money supply causes prices to rise (inflation), since they compensate for the decrease in the marginal value of money.
