1. The Quantity Theory of Money
The quantity theory predicts that changes in the quantity of money affects only prices—not real GDP and employment. We call this the “money neutrality” theorem.

2. The Equation of Exchange
Where
M is the quantity of money
V is the velocity of circulation
P is the price level
Y is real GDP

3. What is velocity (V)?
Velocity (V) is the average number of times per year a unit of money is spent for new goods and services. Let
(P  Y) is nominal GDP. Let P = 1.25; Y = $8 trillion; and M= $2 trillion. Thus:
Or, V = 5

4. Equation of Exchange is Always True
The equation simply states that what is spent for new goods and services (M  V) is equal to the market value of new goods and services produced (P  Y).

5. Illustration Using the numbers on a preceding slide, we can see that
and
thus

6. “Monetarist” interpretation of the equation of exchange
The monetarists believe that price level changes (hence inflation) can be explained by changes in quantity of money
“Inflation is always and everywhere a monetary phenomenon.”

7. Example
Assume that V = 5 and is constant. Y is $8 trillion (also assumed to be constant). Initially, let M = $2 trillion

8. Our basic equation can be rearranged as follows:
Now solve for the price level (P):
Now let the money supply increase to $2.4 trillion. Notice that:
Thus we have:
Notice that:

9. Hence a 20 percent increase in the money supply causes the price level to increase by 20 percent. Monetarists put the blame for inflation squarely at the doorstep of the monetary authorities (in the U.S., the FED).

11. Source: Federal Reserve Board