Question

9. How does the classical quantity theory of money explain the relationship between growth in the money supply and inflation?

Answer 1

Money theory of quantities states that there is a direct relationship between the amount of money in an economy and the price level of goods and services sold. According to QTM, if an economy doubles the amount of money, price levels also double, causing inflation (the percentage rate at which the price level in an economy is rising). Therefore, for the same price of the good or service, the consumer pays twice as much. Another way of explaining this concept is to consider that money is like any other commodity: it raises the marginal value of its supply (the buying power of one currency unit). Therefore, an increase in the supply of money causes prices to rise (inflation) as they compensate for the drop in the real value of money.

Essentially, the premises of the theory mean that the amount of money available in an economy determines the value of money. An increase in the supply of money results in a fall in the value of money because an increase in the supply of money causes inflation to rise. As inflation rises, buying power, or money value, is falling. Therefore, buying the same quantity of goods or services will cost more.

Notwithstanding these criticisms, there are certain merits in the quantity theory of money. If money supply in an economy in the past grew abnormally, there formed an inflationary situation. The relationship may not be reciprocal, but unnecessary increase in the supply of money contributes to inflation.