MAcro CHAPTER 5.3:

CHAPTER SUMMARY

The quantity theory of money is a theory about the relationship between four things:

• M - the money supply (M1)

• V - velocity of money (how many times a dollar gets spent and spent again in a given time period)

• P - price/price level

• Y - the real GDP

The equation for this theory is M x V = P x Y.

• M x V = the money supply times how many times each dollar is spent. So if M is $100 and V is 2 (meaning a dollar added the economy is spent twice in a month), then M x V = $200.

• P x Y = the price level times the Real GDP, which is the Nominal GDP.

The theory states that when one side of this equation goes up, the other side should also go up. A few examples:

• The government increases the money supply (M). There has been no change in Real GDP (Y) or the velocity of money (V), so price levels (P) should rise - inflation!

• Firms start producing more, increasing Real GDP (Y). Because people are now able to buy more, the velocity of money (V) increases accordingly.

It is also possible for all four variables in the equation to change at once, but the theory states that the two sides should always be equal. This theory can help explain inflation, which should occur when M increases but Y and V do not change.

One real-world implication of this is hyperinflation. Governments sometimes print money and add it to the money supply by handing it out - during the COVID pandemic, the United States gave out $1,400 each to every adult citizen. However, doing this should also, according to this theory, increase the price level, since it would not change Real GDP. Some countries have taken this way too far - Zimbabwe is very famous for this - and ended up reaching inflation levels in the billions of percent.

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