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Q. Explain about Quantity theory of money?
One of the main elements of the classical model is quantity theory of money. Quantity theory of money connects three important variables: M, P, and Y: money supply, price level and real GDP.
P.Y is equal to nominal GDP. Assume that nominal GDP is equal to 100 for a certain year whereas the money supply is constant and equal to 20 throughout that year. Because we are using money to buy finished goods, we may determine that each monetary unit (USD or euro or whatever) has been used an average of 5 times during the year (100/20). This value is known as the velocity of money and it is signified by V. We have
V = (P.Y)/M
This isn't a theory however a definition. What makes it into a theory -quantity theory of money - is the assumption that V is a stable variable that doesn't depend on other economic variables. In the quantity theory, velocity of money is an exogenous variable.
The quantity theory of money: M.V = P.Y, V exogenous
The chief consequence of the quantity theory of money is the direct relationship amid M and P if Y is constant. For instance, if money supply increases while real GDP stays the same, P will increase exactly as much as M (in percentage).
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