Quantity Theory of Money:
The theory suggests the existence of a direct relationship between money supply and the average price level in the macro economy. Specifically the quantity theory of money states that the price level is strictly proportional to the money supply.
The quantity of money which was pioneered by the 18th century economists including Adam Smith and David Hume, was modified and popularized in 1911 by the American Economist, Irvin Fisher (1867 - 1947) in what is known equation of exchange:
MV = PQ Where M = Total money supply
V = velocity of circulation of each unit of money
P = average price level
Q = real national output or real GNP
The assumptions of the theory are that:
(i) The velocity of money circulation (V) is fixed.
(ii) The real GNP denoted (Q) is fixed in the short - run.
(iii) The money stock (M) is determined from time to time by the country's monetary authorities.
(iv) The economy is at full employment level.
Given the above assumptions, the equilibrium price level (P) is determined by the money stock (M) as expressed in equation (1)
P = MV/Q
Equation (1) which presents the quantity theory of money is obtained by making P the subject of the relation in equation (1). It follows, for example, that a 5 percent increase in money stock will cause average price level in the economy to rise by 5 percent. Thus, inflation is conceived as a monetary phenomenon.
The major policy implication of the theory is that monetary policy of the restrictive type, is most relevant for effective control of inflation. In other words to curb the problem of inflation effectively requires the reduction of money stock through the use of monetary policy instruments such as open market operations (OMO) reserve requirements, and bank rate.
The weakness of the quantity theory of money lies in the underlying assumptions, especially the assumption of fixed output and fixed velocity of money circulations which are unrealistic.
However, the theory provides a guide to the government to regulate money supply along the rate of changes in national output so as to avoid the problem of inflation.