Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Examining the Cause of Inflation: The Quantity Theory of Money

Is inflation an inevitable force of nature, or are there underlying causes that allow policy makers to have some control over it? In this section, you see that economists have a good idea about what causes inflation and how policy makers – if they are disciplined – can control it.

In this section we introduce you to the following:


The quantity theory of money: Explains the underlying cause of inflation in the long run, which is the growth in the amount of money in the economy.


The quantity equation: The relationship between money, how fast it circulates, prices and income.

We show what economists can discover from the quantity equation and why it isn’t really an equation at all, but an identity!

Trying out the quantity equation

We derive the quantity theory of money as follows:

This quantity equation says that the amount of money (M) multiplied by the velocity of circulation (V) is equal to the price level (P) multiplied by total output (Y).

To see why this is true, take a look at the right-hand side of the quantity equation (PY). This is how much money you’d need in order to purchase all the output in the economy (at current prices). In other words, this is nominal GDP (check out Chapter 4).

In the left-hand side of the quantity equation (MV), V is the velocity of circulation, which measures how quickly money circulates around the economy, or in other words, how often money changes hands: the more that money changes hands, the more expenditure on goods and services in the economy. Therefore, MV represents the total amount of expenditure in the economy.

As we describe in Chapter 2, (the value of) total expenditure in an economy is just the same as (the value of) total output. The quantity equation expresses this idea succinctly.

The quantity equation is written in ‘levels’, however, whereas we want to know about the growth rate of prices (inflation), not the level of prices. But a

simple trick allows you to go from levels to growth rates, which if applied to the quantity equation, yields:

where g_X is the growth rate of variable X and g_P is the growth rate of prices (that is, inflation). Although the velocity of circulation (V) may vary from year to year, it's unlikely to grow in the long run. If you plug in g_P = π and g_V = 0 and rearrange you have:

This expression says that the rate of inflation (π) is equal to the rate of growth of money minus the growth rate of output.