9.4.3—Quantity theory of money

The quantity equation is MV = PY: money supply times velocity equals the price level times real output. It becomes a theory of inflation only when assumptions about velocity and real output are made.

If velocity is stable and real output is determined by real factors in the long run, a sustained increase in money can raise the price level. In the short run, velocity, spare capacity and expectations may change.

If M rises 5%, V and Y are unchanged, the equation implies P rises about 5%. If banks hoard liquidity or output responds, the price effect is different.

MV=PY is an identity in measured data; the causal claim that money causes proportional inflation needs the additional assumptions.