Economics – Money and banking | e-Consult

Assumptions of the Quantity Theory of Money:

• Velocity of Money (V) is relatively constant: This assumes that people spend their money at a fairly consistent rate. This is a significant simplification, as spending patterns can change due to factors like interest rates and consumer confidence.
• Real Output (Q) is determined by real factors: This assumes that the economy's output is primarily determined by factors like technology, labour, and capital stock, rather than by monetary policy.
• Price Level (P) is fixed: This is a highly unrealistic assumption. In reality, the price level is constantly changing, and the quantity theory of money is most applicable over longer time periods.

Relevance to Inflation:

The quantity theory of money posits that an increase in the money supply (M) will lead to a proportional increase in the price level (P). This is because if there's more money chasing the same amount of goods and services, prices will rise.

Evaluation in Modern Economies:

While the theory provides a useful framework, its relevance to modern economies is debated. The velocity of money is not constant, and the relationship between money supply and inflation is often weak and variable. Factors like global supply chains, changes in financial innovation, and the effectiveness of central bank policy can all influence the relationship. However, the theory remains a valuable tool for understanding the potential link between monetary policy and inflation, particularly over the long run. It highlights the importance of controlling money supply growth to maintain price stability.