The quantity theory of money states that inflation increases when the total quantity of money increases. The theory has been around for centuries and has undergone criticism, but the mathematical formula M*V=P*T is accepted as the basic equation of how a money supply relates to monetary inflation. Critics argue that velocity is unpredictable and the theory is a poor indicator of short-term finances.
The quantity theory of money states that inflation increases in an economy when the total quantity of money increases. This theory of inflation attempts to assign an actual value to money and explains why the price of items increases when items remain physically the same, such as a gallon (3.8 liters) of milk. This theory has been around for centuries and has undergone a tumultuous history among economists. Many see this as a simple solution to this question, but many others criticize the theory.
The theory of the quantity of money is believed to have originated in the 16th century. This was a direct response to rising prices due to the influx of gold and silver from the Americas into Europe. In the early 1800s, economist Henry Thorton created what has been considered the definitive statement on monetary economics. His theory essentially stated that the more money that enters an economy, the higher the inflation, and that increasing the money supply does not necessarily lead to an increase in economic output.
As far as economic theories are concerned, the quantity theory of money is one of the simplest to understand. An example would be that when the amount of money in an economy doubles, prices eventually double. This is explained because as more and more money is fed into an economy, it becomes much less rare, thus losing its initial value. So in most economies, this produces a cycle, because the goal is to add income to the system, but by doing so, the value of money decreases, creating a greater need for income, and so on.
The quantity theory of money has been explained using a simple equation that can be applied to many different economies. The mathematical formula M*V=P*T is accepted as the basic equation of how a money supply relates to monetary inflation. The letter M stands for money; the V stands for speed, or the number of times hands exchange money; the P stands for the average price level; and the T represents transaction volume.
This economic theory has many followers who agree that this simple solution is accurate, but since Thorton made his ideas public, there have been some critics. As early as the work of famed 20th century economist John Maynard Keynes, many argued that velocity is unpredictable and therefore impossible to measure accurately. Many also see the quantity theory of money as an accurate judge of long-term economics but a poor indicator of short-term finances.
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