- It is a theory that shows direct relationship between money supply and the price level.
- It is a theory that shows that the general price level is proportional to money supply.
The above implies that the price level and quantity of money (money supply) vary proportionately. That is, a certain level or percentage (10%) change (increase or decrease) in money supply also leads to the same percentage (10%) change (increase or decrease) in the, general price level.
The quantity theory of money is one of the theories that try to explain what happens when there is an imbalance between the demand for money (by households and firms) and the supply of money to these economic units. The theory explains that if people hold more money than they require (i.e. if there is an excess supply of money over demand), they will spend the surplus on currently produced goods and services. This will increase the price level.
The quantity theory of money also states that an increase in the quantity of money in circulation would bring about services. Professor Irving Fisher remodified the quantity theory of money into what is known as velocity of circulation of money.
Velocity of circulation of money, according to Professor Fisher, refers to the speed at which money circulates within the economy by changing from one hand to another. When there is an increase in the velocity of circulation of money, prices will increase leading to a lower value of money.
The theory was developed (modified) by Irving Fisher in 1933 by expressing it in Equation of Exchange (Quantity of Money Equation) as follows:
MV = PT
M = Quantity of money in circulation (total amount of money supply).
V = Velocity of circulation (number of times a unit of money, a naira, changes hand in the economy (country) in a year).
P = General price level (average price of goods and services in a given period, say in a year).
T = Volume of transaction (number of transactions; i.e. number of times people buy goods and services. In other words; total amount of goods and services available for sale in a year).
MV = Money supply multiplied by velocity of circulation of each unit of money in use. This gives us the total amount of money in the country or total expenditure on goods and services in a country per year.
PT = General price level multiplied by total number of transactions in which money is involved. It gives total value of all goods and services produced in a country per year.
The above implies that total expenditure on goods and services or total amount of money in circulation (spent) in a year should be equal to total value of goods and services produced in a year in a given country.
An important inference (conclusion) from the Quantity Theory of Money is that the general price level can be influenced (changed) not only by the amount of money supply but also by the rate at which a unit of money circulates (changes hands). Prices can go up even though money supply remains constant if the rate at which a unit of money changes hands increases, and vice versa.
From the exchange equation, we can determine the value of any of the variables (items) by making it the subject of the equation as follows:-
Example 1: Find the total amount of money supply in Nigeria in 2010, if average price of goods and services was N100, total value of business transactions was N20 billion and velocity of circulation of a unit of money was 100.
Example 2: Find the rate at which a naira circulates (changes hands) if money stock (total money supply) is N50 billion, the general price level is N25 and total value of business transactions is N150 billion per year.