5.5: The Quantity Theory of Money I

The quantity theory of money is a classic economic model that explains the relationship between money and prices. It considers four elements: the total supply of money, how quickly money circulates, the general level of prices, and the number of transactions taking place. Together, these factors show how changes in money supply can influence the cost of everyday goods and services.

Consider a small community where a single ten-dollar note changes hands several times in one day. A customer buys fruit at the market, the seller pays a carpenter, and later the carpenter spends the same note at a café. Although only one note exists, it supports three separate trades. This illustrates how the velocity of money—the speed at which money circulates—affects economic activity.

The theory assumes that, in the short run, both the velocity of money and the number of transactions remain relatively stable. Under these conditions, changes in the money supply directly affect prices. An increase in money supply tends to raise prices, while a decrease tends to lower them. In simple terms: too much money chasing the same amount of goods pushes prices up; too little money slows trade and reduces prices.

Because of this, managing the money supply is central to economic stability. If money grows too quickly, inflation follows; if it grows too slowly, trade and production may stagnate. The quantity theory of money provides a straightforward lens for understanding how money, spending, and prices interact, making it a cornerstone of monetary policy and inflation control even today.

In a small town, Jordan pays one dollar to buy a slice of pizza from Sam, who runs a food truck.

Later, Sam uses that same dollar to pay for his son’s ride on the carousel at the local carnival.

Then, the ride operator, Tom, uses that dollar to buy a comic book from a nearby bookstore.

This dollar moves from one person to another and is used three times—for pizza, a ride, and a comic book.

This example shows how the Quantity Theory of Money connects money, spending, and prices.

The theory involves four key variables: M is the money supply, V is the velocity of money—how often each dollar is spent, P is the average price level, and T is the total number of transactions. The relationship is shown by the equation MV = PT.

In our example, M is one dollar, V is three, since the dollar is used three times, the average price level, P, is one dollar, and T is the number of transactions involving goods and services bought: pizza, a ride, and a comic book.

The theory assumes V and T stay stable in the short term, so changes in M directly affect the price level, P.