5.6: The Quantity Theory of Money III

Economists often adapt the quantity theory of money by replacing transactions with output. Counting every single exchange in an economy is nearly impossible, so they use the value of all newly produced goods and services—real GDP (Y). This measure captures overall activity without double-counting secondhand sales or repeated trades of the same item.

In this form, the equation states that:

M × V = P × Y

• M is the money supply
• V is the velocity of money
• P is the price level
• Y is real GDP

It’s important to remember that this equation is an identity—true by definition. The quantity theory of money uses this identity to make predictions by assuming that the velocity of money (V) and real output (Y) are relatively stable.

The left side reflects money being spent, while the right side represents the value of what is produced and sold. Because each purchase is also income for someone else, the two sides must always balance.

To make this more concrete:

• Velocity (V) can also be written as V = (P × Y) ÷ M, meaning the average number of times a dollar is used to purchase final goods and services in a year.
• Price level (P) is usually measured by a price index such as the Consumer Price Index (CPI) or the GDP Deflator, linking the theory to real-world statistics.

Although transactions and output are not identical, they move closely together. For example, a new pair of shoes produced and sold in a factory counts toward output, but a resale of used shoes at a flea market does not. Both are transactions, but only the first adds to current production. This distinction ensures that economic activity is measured accurately.

Another useful concept is real money balances (M ÷ P), which describe what the money supply can buy at current prices. In other words, they measure purchasing power in terms of goods. When prices rise, the same amount of money buys less—showing how inflation erodes value.

This perspective makes the theory a practical tool for understanding the link between money, output, and prices in everyday life.

Economists use an updated form of the quantity equation where the value of total output adjusted for inflation (Y) replaces the total number of transactions (T). This is because tracking every transaction is nearly impossible, while output data is more reliable and easier to measure.

Transactions and output are not identical, but they are closely related. More output usually means more transactions, but more transactions don’t necessarily imply more output. For example, buying a comic book is a transaction. But if it's secondhand and not newly produced, it doesn't count as current output.

The adapted equation is MV = PY, where M is the money supply, V is the velocity of money, P is the average price level, and Y is the inflation-adjusted total value of all final goods and services produced, also known as real GDP.

Together, P × Y represents nominal GDP, the total dollar value of goods and services produced.

Economists use real money balances (M/P) to show how many units of the average good the money supply can buy—for example, if M is $500 and P is $1, the money supply can purchase 500 goods.