Quantity Theory Of Money: Case Study

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The Quantity theory of money states the direct relationship which exists between money supply and prices in the economy. It says that as money supply in the economy changes, price changes in the same direction too. That is if money supply increases, consumers will have more money in hand to spend, thereby demanding the more goods and services which shifts the demand curve to the left, keeping supply constant leading to a rise in the price level. In similar context when money supply falls, the price level decreases too.
The Quantity theory of money is represented by the following equation:
MV = PT
M = Money supply V = Velocity of Circulation P = Price Levels T = Transactions
T represents the total no. of transactions during a period
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V in this version of the quantity equations is called the income velocity of money. M/P is called the real money balances. The money demand function is an equation that shows what determines the quantity of real money balances people wish to hold. This equation states that the quantity of real money balances demanded is proportional to real income.
(M/P)^d = ky
A 6 year case study of Romania’s economy has proven with over 95% accuracy that an increase in M (money supply) resulted in inflation – a persistent increase in the price levels at assumed values. (1) This reinforces the QTM is valid and is some empirical evidence supporting the QTM. In the early 1980s there was strict money supply controls in the UK attempting a quick fix of the level of inflation by the newly appointed conservative government which however backfired as it caused a deep recession. This shows that the QTM is valid more in the Long Term as values become more accurate over a given period of
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Due to hot money flows, investors are more likely to save their money in British banks if the UK interest rates are higher than other countries as they will seek the benefits of a higher return in payments. However a stronger pound makes UK exports less competitive lowering exports and leading to an increased dependence on imports hence lowering the total value of net exports. This has the effect of decreasing Aggregate Demand in the economy as net exports are also a component.

• There can be a decrease in terms of the economic growth. A Bank of England research paper has estimated that raising interest rates by 1% will reduce the total output by 0.6% over a 2 year period. What this means is that a even a quarter point rise would trim a modest 0.15% from GDP which is equivalent to 6 weeks worth of growth at current rates.(3)

• Previous historic economic events show that UK in the past hasn’t reacted well to a rise in the interest rates. In 1979 there was a 17% rise in the rate of interest when the newly appointed conservative government tried to control inflation. However this backfired as the UK went into recession the following year. (4) A recession in termed to be very alarming for an economy as unemployment rate rises, GDP (Gross Domestic Product) growth slows, and housing price

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