The equation of exchange shows how the amount of money in circulation affects price levels and inflation. More money leads to higher prices, and equilibrium is reached when demand is met and the money supply is exhausted.
The equation of exchange is an economic theory that shows the effect that the amount of money within a society has on price levels. According to the equation, the amount of money is multiplied by the speed with which it is spent to equal the amount spent. This part of the equation is equal to the price level multiplied by the amount of transactions. In general, the equation of exchange shows that more money within a society ends up causing inflation.
Economists are often concerned with the reasons why prices rise and fall within a specific society and the effect that prices have on the general economic health of the society. Inflation can do serious damage to the poorest members of society, so keeping price levels at a reasonable level is critical. As more money circulates throughout society, it tends to raise prices. This is the basic principle of the quantity theory of money, and the equation of exchange is designed to show how it works.
As an example of how the equation of exchange works, imagine that there are 50 units of money in a society. Those 50 units are spent in total five times in a given period of time. The five times is the velocity in the equation, or V, and the 50 units is the money supply, or M. Multiplying M by V yields the amount of spending, which means, in this case, that spending is 250 units. , or five times 50.
On the other side of the exchange equation is the reaction of the economy’s producers. This part of the equation is price, or P, multiplied by transactions, or T. If producers of goods set the average price at 25 units, this means that the quantity of transactions would be achieved by inverting the equation and dividing expenditures of 250 units by 25, resulting in a total of 10 transactions in that period.
What the equation of exchange shows is that price levels are directly affected by the amount of money in circulation. As more money pours into society, producers can react in kind by raising prices to keep up with the increased demand for their products. Equilibrium will be reached when the demand is met and the money supply is exhausted. At that point, prices will start to fall, creating a kind of circular pattern between buyers and sellers.
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