Inflation and Quantity Theory of Money

Relationship Between Money Supply, Monetary Policy, and Inflation

• Equation of exchange:
  • $M_s * v = p * y$
    • $M_s$ = Money supply
    • $v$ = Velocity
    • $p$ = Price level
    • $y$ = Real GDP per year

Quantity Theory of Money and Prices (Irving Fisher)

• Theory: Relationship between growth in the money supply and growth in the price level.
• Hypothesis: Changes in the money supply lead to equal proportional changes in the price level (inflation or deflation).
  • How Fisher arrived at this hypothesis:
    • He assumed that $v$ (velocity of money) was constant.
    • He assumed that $y$ (real GDP) was also relatively stable.

Assumptions

• Velocity ($v$) is constant:
  • The rate at which money is respent remains relatively stable.
  • Increased spending is due to having more money, not recycling the same amount of money faster.
• Real GDP ($y$) is stable:
  • Production of goods and services remains fairly constant.
  • Small fluctuations may occur, but overall stability is maintained.
• Implications:
  • If $v$ and $y$ are constant, then $M_s = p$
  • If the money supply grows by 10%, the price level will also rise by 10