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What is equation of exchange?

Updated: 12/19/2022
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Q: What is equation of exchange?
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Does increase in money supply always lead to proportional increase in prices?

An increase in money supply leading to an equal increase in prices is referred to as the "Quantity Theory of Money". To explain this theory, we first need to define the "velocity of circulation" and the "equation of exchange". The velocity of circulation is the average number of times a dollar of money is used annually to buy GDP. But GDP equals the price level (P) multiplied by real GDP (Y). that is: GDP = PY. Call the quantity of money M. The velocity of circulation, V, is determined by the equation V = PY/M For example, if GDP is $900 billion (PY = $900 billion) and the quantity of money is $225, the velocty of circulation is 4. ($900billion divided by $225 billion equals 4). The equation of exchange states that the quantity of money (M) multiplied by the velocity of circulation (V) equals GDP, or MV = PY This equation is always true - it is true by definition. With M equal to $225 billion, and V equal to 4, MV is equal to $900 billion, the value of GDP. In this case, the equation of exchange tells us that a change in quantity of money brings about an equal change in the price level. You can see why by testing the equation by increasing the supply of money and price level by the same amount - the equation holds true.


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