Question

The quantity theory of money states that the quantity of money available determines the price level and that the growth rate in the quantity of money available determines the inflation rate. Using an appropriate diagram, explain the adjustment process in the case of decrease in the money supply.

Answer 1

The Quantity Theory of Money states that the positive relation between price level and money supply. When money supply increased the price level will rise upward. Price is the function of money supply. If the money supply rises doubled the price level also become doubled. From Fisher's equation, MV = PT Where, M is the money supply, V is the velocity of money, P is the price level and T is the total transaction level of goods and services. According to this theory, holding of money is meaningless. So people tried to increase their transaction through purchasing goods and services. This high level purchase will raise the price level. With rise in price level the demand for money increased. This will continue until the demand for and supply of money equates. Price level M1 P1 PO M2 P2 P* M2 MO MT Money supply Value of money 1/P2 1/PO 1/P 1/(M) M* M2 MO M1 money supply If the money supply reduced, the value of money will increase and the price level will fall down.