The quantity theory of money

The quantity theory of money was formulated in the 1700s. The quantity theory of money seeks to explain how changes in the money market affects the prices of products.

The quantity theory of money assumes that the central bank controls the supply of money and that the demand for money always will be equal to the money supply. The quantity theory of money therefore assumes that it always is a balance in the money market. The quantity theory shows that there is a direct correlation between money supply and the price level. Increased money supply results in an increased price level in the country. The quantity theory is summarized in the equation: MV = PQ

where:
M = Money
V = Velocity of circulation
P = Price
Q = Quantity

The quantity theory of money assumes V and Q to be constant in the short term, this means that there is a direct relationship between money supply and the price level. If the central bank can control the money supply, it can also control the price level.