QUANTITY THEORY OF MONEY AND BUSINESS CYCLE

M stands for

Money supply

V stands for

Velocity of circulation

P stands for

Price level (inflation)

Q stands for

Quantity of goods and services

Equation

MV = PQ

Assume that V and Q are unchanged so that…

increases M led to directly increases P (increases in the money supply led to inflation)

If the money supply doubles

the price level doubles

V can change due to

• changes in inflationary expectations, e.g. when prices are rising rapidly, people will be reluctant to hold money as it is losing purchasing power so V increases. 

• changes in time of year (e.g. Xmas)

• changes in consumer confidence.

Q can change due to 

•  During a recession, production  and therefore Q will fall.  During a recovery, production picks up, so Q starts to rise again.

• Therefore… neither V or Q are constant

The business cycle

Peak → Recession → Trough → Recovery → Peak

If the economy is operating near full capacity there will be very little room for

Q to increase as nearly all resources are fully employed. Therefore the P (general price level) will rise in response to the increase in M.

If the economy is operating under full capacity  (excess capacity) it

has the potential to utilise idle resources. So Q would be able to increase and would (partly)  offset any increase in P.