Monetary Policy - Inflation - Causes

Theory 3 - Quantity theory of money - in theory what quantity would you like?

The classical economists view of inflation revolved around this theory, and this theory was in turn derived from the Fisher Equation of Exchange. This equation says that:

MV = PT

where:
M is the amount of money in circulation
V is the velocity of circulation of that money
P is the average price level, and
T is the number of transactions taking place

The equation is in fact an identity/truism. It says that the amount of the money stock times the rate at which it is used for transactions will be equal to the number of those transactions times the price of each transaction. It will always be true, as it simply says that National Income will be equal to National Expenditure and basic macroeconomics tells us that this is true anyway. So nothing stunning there! However, what makes it important is what classical economists predicted from it.

Classical economists suggested that V would be relatively stable and T would always tend to full employment. Therefore they came to the conclusion that:

In other words increases in the money supply would lead to inflation. The message was simple; control the money supply to control inflation.