Quantity Theory Of Money

The quantity theory has been around for at least a couple hundred years. It’s the theory that M x V = P x Y where:

M is the money supply (how many dollars are floating around). V is the velocity of money (how many times each of those dollars was spent). P is the price of goods and services sold (all those price tags you see at the store, or online). Y is the amount of goods and services sold.

The M x V part is the buyer part of the equation. The amount of dollars in the system times the velocity of those dollars equals…what, exactly? Nominal GDP. This measures how many dollars are moving through the system in a given year.
The seller side is P x Y, which is the amount goods and services sold (Y) times their prices (P). This is another way to measure nominal GDP, but from the seller side.

Since the money earned from the seller’s side should equal the money spent from the buyer’s side, both sides of this equation should be equal...to nominal GDP.

The quantity theory of money shows what happens when we get inflation, too. When prices go up, nominal GDP goes up, but not necessarily real GDP. Think about it: just because things are more expensive doesn’t mean more value is being added to the economy. When P goes up, it’s oftentimes because M, the money supply, has gone up.

This is why it’s bad news bears to introduce too much new money into the money supply...it’ll likely just lead to inflation, even hyperinflation or stagflation. While this is an interesting theory, there’s dispute as to its usefulness in real life. These factors are hard to measure, especially on a macroeconomic scale. Plus, there are some assumptions, like that V, the velocity of money, is constant.