In the income-expenditure model we assumed that investments were fixed and that business made no trade offs. In reality they do. In order to get a complete overview of all the basic forces that drive the economy we need to bring the function of money and the effect of interest rates into our overall thinking. Equation of Exchange Money is an integral part of the workings of the economy. Goods, labor and services flow through the economy in one direction and money follows the exact opposite trail.
Money circulation has two elements to it.
First there is quantity or amount of money that circulates, secondly there is the speed with which it circulates. This can be easily explained with an example. This is called the equation of exchange . The equation of exchange is a foundation on which the quantity theory of money is built. The quantity theory of money argues that inflation is caused by rapid increases in the quantity or money in circulation, and that deflation is caused by decreases or very slow increases in the quantity of money in circulation.