Quantity Theory Of Money

Quantity Theory of Money (QTM) is a theory about relationship between amount of money and the value of goods and services being sold in the economy. The general idea of it is that there is direct proportional relationship between the supply of money and the price level. Following that, doubling or tripling of supply of money will result in proportional increase in prices respectively.

To understand this further you can relate to the simple idea of Supply and Demand and treat money as goods. So if the supply of money will increase from Supply 1(Orange) to Supply 2(Grey), thus shifting equilibrium from point X to point Y. Demand remains the same, value goes down while quantity increases.

This means that value of money is going down with a bigger

T(Y) - Total volume of transactions or output. This value gives the information on total volume of goods and services transacted in the economy. T is also remains fixed due to assumption of full employment in economy.

As a result, V and M in these calculations are used in order to determine total expenditure in the economy, which is given by MV. Likewise multiplication of P and T(Y) will give the the total value of transacted goods in the economy given by PT(PY). Following this logic, total expenditure on goods and services should be equal to the value of all transacted goods and services. Therefore, as V and T(Y) are fixed, increase in money supply (M) will result in increase of price level (P) which causes inflation.

As an empirical evidence, post WWI hyperinflations in Germany, Austria and Russia can be a great example. Because of extra need in higher government expenditure to finance different matters during wartime, the supply of money was substantially increasing, resulting, at first, in slower growing than money supply prices, due to time lag, but then catching up and eventually turning into hyperinflations, especially during post war times. Not only WWI, but also time before and after WWII was a period of rapid growth of prices in some countries like Greece, Hungary and a few others.

Possibility of hot money flow. High interest rates might be attractive enough for foreign investors and increase their incentives to save in UK, this way demand for £ will increase and cause appreciation of currency. Appreciation as a result will make exports less attractive and less competitive on global market; likewise, imports consumption might rise, as they will be more attractive domestically. Although, this is likely to have minimal impact due to recent depreciation of the currency and strong global expansion

All of those changes result in falling aggregate demand (AD) (which consists of Consumption, Investment, Government Spending and Net Exports), as investment, consumption and net exports all will be reduced. Following diagram will help understand how this affects economy.

Since AD is falling (AD 1 to AD 2) the equilibrium shifts from point X to Z, this causes price level to fall from P1 to P2, thus reducing inflation. However, there is another problem arising because of that, because AD is falling, economy is no longer able to grow at the same rate. Additionally, falling AD could cause unemployment of Yfe-Y1.

As a result, implying higher interest rates will help with achieving lower inflation rate, but it could incur additional problems such as slower economic growth,