Definition
Quantity Theory of Money
The quantity theory of money states that the general price level is proportional to the money supply, captured in the equation MV = PT (money times velocity equals price times transactions).
The identity MV = PT links money supply (M), velocity (V), the price level (P) and the volume of transactions (T). If velocity and output are stable, increasing the money supply raises prices proportionally, the monetarist core.
It explains why printing money to fund deficits eventually causes inflation. In practice, velocity is not constant, so the link between money growth and inflation is looser than the simple theory suggests, which the RBI accounts for in policy.
Related terms
- MonetarismMonetarism, associated with Milton Friedman, holds that the money supply is the primary driver of inflation and economic activity, and that steady money growth is the best policy.
- Velocity of MoneyThe velocity of money is how many times a unit of currency is spent on goods and services in a given period; higher velocity means money circulates faster through the economy.
- Money Supply (M0 to M3)Money supply measures the total money in an economy, classified into M0, M1, M2 and M3 by liquidity, from physical cash to broader deposits.
- InflationInflation is the rate at which the general level of prices rises over time, steadily eroding the purchasing power of money and the real value of savings.
Plain-English explainer from The Dispatch Investors Encyclopedia. General information, not financial advice.