# Understanding the Quantity Theory of Money: Key Concepts, Formula, and Examples

## What Is the Quantity Theory of Money?

The Quantity Theory of Money links price variations to changes in the money supply, forming an essential part of economic theories like monetarism. Commonly illustrated by the Fisher Equation, this theory helps explain inflation, providing valuable insights for both novice and expert investors. Understanding this concept is crucial for anyone looking to grasp the broader implications of economic dynamics in relation to money supply.

### Key Takeaways

*   The quantity theory of money posits that changes in money supply are directly proportional to changes in price levels.  
    
*   Irving Fisher's equation, MV = PT, is central to monetarism, suggesting that money supply and velocity affect prices and transactions.  
    
*   Critiques of the theory often focus on its assumptions of constant velocity and stable economic variables.  
    
*   Monetarists, Keynesians, and Austrians offer varied interpretations of the theory, emphasizing different economic dynamics.

![Quantity Theory of Money: A theory that variations in price relate to variations in the money supply.](https://www.investopedia.com/thmb/ljONOz5Fn09F0LDBk3jwEpGH3Ss=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/quantity_theory_of_money.asp-final-a0803f5f884b4d9e8ae370b2d1cc2fe1.png)

*— Investopedia / Julie Bang*

## Breaking Down the Quantity Theory of Money

The most common version, sometimes called the "neo-quantity theory" or Fisherian theory, suggests there is a mechanical and fixed proportional relationship between changes in the money supply and the general price level. This popular, albeit controversial, formulation of the quantity theory of money is based upon an equation by American economist Irving Fisher.

The Fisher equation can be written as:

$\begin{aligned} &\text{M} \times \text{V} = \text{P} \times \text{T} \\ &\textbf{where:} \\ &\text{M} = \text{money supply} \\ &\text{V} = \text{velocity of money} \\ &\text{P} = \text{average price level} \\ &\text{T} = \text{volume of transactions in the economy} \\ \end{aligned}$

The quantity theory of money shows that more money usually leads to [inflation](https://www.investopedia.com/terms/i/inflation.asp), and less money can reduce prices. The original theory assumes V is constant and T is stable, meaning changes in M directly affect P. In other words, if the money supply increases then the average price level will tend to rise in proportion (and vice versa), with little effect on real economic activity.

For example, if the Fed or [ECB](https://www.investopedia.com/terms/e/europeancentralbank.asp) doubled the money supply, prices would likely rise sharply. More money means more spending, which drives up prices.

## Analyzing the Critiques of Fisher's Theory

[Economists](https://www.investopedia.com/terms/e/economist.asp) disagree about how quickly and how proportionately prices adjust after a change in the quantity of money, and about how stable V and T actually are with respect to time and to M.

> **Important**
>
> The classical treatment in most economic textbooks is based on the Fisher Equation, but competing theories exist.

The Fisher model has many strengths, including simplicity and applicability to mathematical models. However, it uses some assumptions that other economists have questioned to generate its simplicity, including the neutrality of the money supply and transmission mechanism, the focus on aggregate and average variables, the independence of the variables, and the stability of V.

## Exploring Alternative Theories to Fisher’s Model

### Monetarists

[Monetarist](https://www.investopedia.com/terms/m/monetarist.asp) economics, usually associated with [Milton Friedman](https://www.investopedia.com/terms/m/milton-friedman.asp) and the Chicago school of economics, advocate the Fisher model, albeit with some modifications. In this view, V may not be constant or stable, but it does vary predictably enough with business cycle conditions that its variation can be adjusted for by policymakers and mostly ignored by theorists.

Monetarists often support a steady increase in money supply. While not all economists accept this view, more economists accept the monetarist claim that changes in the money supply cannot affect the real level of economic output in the long run.

### Keynesians

Keynesians more or less use the same framework as monetarists, with few exceptions. [John Maynard Keynes](https://www.investopedia.com/terms/j/john_maynard_keynes.asp) rejected the direct relationship between M and P, as he felt it ignored the role of interest rates. Keynes also argued the process of money circulation is complicated and not direct, so individual prices for specific markets adapt differently to changes in the money supply.

His theory emphasized that velocity (V) is not constant or stable, but can swing widely based on optimism or fear and uncertainty about the future, which drives [liquidity preference](https://www.investopedia.com/terms/l/liquiditypreference.asp). Keynes believed inflationary policies could help stimulate aggregate demand and boost short-term output to help an economy achieve [full employment](https://www.investopedia.com/terms/f/fullemployment.asp).

### Knut Wicksell and the Austrians

The most serious challenge to Fisher came from Swedish economist Knut Wicksell, whose theories developed in continental Europe, while Fisher's grew in the United States and Great Britain. Wicksell, along with [Austrian economists](https://www.investopedia.com/terms/a/austrian_school.asp) such as [Ludwig von Mises](https://www.investopedia.com/terms/l/ludwig-von-mises.asp) and Joseph Schumpeter, agreed that increases in the quantity of money led to higher prices.

In their view, however, an artificial stimulation of the money supply through the banking system would distort prices unevenly, particularly in the [capital goods](https://www.investopedia.com/terms/c/capitalgoods.asp) sectors. This, in turn, shifts real wealth unevenly and could even cause [business cycles](https://www.investopedia.com/terms/b/businesscycle.asp).

The dynamic Wicksellian, Austrian, and Keynesian models stand in contrast to the static Fisherian model. Unlike the monetarists, adherents to the later models don't advocate a stable price level in monetary policy.

## What Is the Quantity Theory of Money in the Simplest Terms?

In simple terms, the quantity theory of money says that an increase in the supply of money will result in higher prices. This is because there would be more money, chasing a fixed amount of goods. Similarly, a decrease in the supply of money would lead to lower average price levels.

## What Are the Assumptions of the Quantity Theory of Money?

The quantity theory of money depends on three assumptions about the relationship between money and real economic activity. First, it assumes that real economic output is determined by the factors of production, and independent of the money supply. It also assumes a one-way causal relationship where the money supply affects prices, but not vice versa. The final assumption is that the velocity of money, or how frequently money changes hands, is a constant.

## What Are the Limitations of the Quantity Theory of Money?

While the quantity theory of money can provide some useful generalizations about the role of money in an economy, it also relies on some assumptions that have been criticized by economists. One of the biggest is the assumption that the velocity of money is constant, and that other factors will remain fixed as the supply of money increases. In a real-world economy, each of these variables is likely to fluctuate due to changes in consumer behavior and interest rates. Moreover, the theory may be ineffective at predicting outcomes in situations with interests rates at or near zero, a situation known as a [liquidity trap](https://www.investopedia.com/terms/l/liquiditytrap.asp).

## Key Insights and Final Thoughts on Money Supply

The quantity theory of money suggests a direct relationship between the money supply and price levels, notably through Irving Fisher's equation of exchange. This theory, critical to monetarism, posits that increasing the money supply leads to inflation when the velocity of money and transaction volume are stable. However, economists like Keynes and Wicksell offer alternative views, highlighting the indirect and complex nature of this relationship. While the theory provides a framework for understanding money’s impact on prices, its assumptions about constant velocity and independent real economic output invite debate among economists.

> **Article Sources**
>
> 1.  EconPort. "[The Quantity Theory of Money](https://www.econport.org/content/handbook/Inflation/MoneyIn/Quantity.html)."