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quantity theory of money


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The theory that the price level is proportional to the quantity of money. This is expressed by the quantity equation, MV = PT, where M is the quantity of money, V is the velocity of circulation, P is the price level, and T is the volume of transactions. The quantity theory assumes that T is determined by supply-side forces, which determine the level of real output, and institutional factors, which determine the ratio of total transactions to output; and V is determined by the legal status and operating habits of the financial system. These assumptions allow T and V to be treated as fixed. The quantity equation then implies that P must be proportional to M. This reasoning supports the assertion of Milton Friedman (1912–2006) that inflation is caused by increases in the money supply. If T and V are not taken as fixed the direct link between money and prices is lost and a broader range of economic considerations enters the analysis.

Subjects: Economics.


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