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What is the quantity theory of money?
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18. Monetary Policy
Quantity Theory of Money
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According to the Quantity Theory of Money, if real output (y) and velocity (v) are constant and the money supply (m) doubles, what happens to the price level (P)?
A
The price level is halved.
B
The price level increases by less than double.
C
The price level remains unchanged.
D
The price level doubles.
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Recall the Quantity Theory of Money equation: \(M \times V = P \times Y\), where \(M\) is the money supply, \(V\) is the velocity of money, \(P\) is the price level, and \(Y\) is the real output.
Understand that the problem states both real output (\(Y\)) and velocity (\(V\)) are constant, meaning they do not change when the money supply changes.
Since \(Y\) and \(V\) are constant, any change in the money supply (\(M\)) must be matched by a proportional change in the price level (\(P\)) to keep the equation balanced.
If the money supply (\(M\)) doubles, then to maintain the equality \(M \times V = P \times Y\), the price level (\(P\)) must also double because \(V\) and \(Y\) are fixed.
Therefore, the price level increases proportionally with the money supply when velocity and real output are constant.
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