Chapter 14, Problem 1QP

To determine

The assumptions and predictions of simple quantity theory of money.

Explanation of Solution

The quantity theory of money assumes that the velocity and output remains constant. When this assumption holds good, there exists a proportional link between the changes in money supply and the changes in prices. However, it is evident that in the real world, a strictly proportional relationship between the money supply and the price level do not exist. However, there is a strong direct relationship between the changes in money supply and prices. Thus, the quantity theory is capable of predict to an extent.

Economics Concept Introduction

Quantity theory of money:  The Quantity theory of money refers to the relationship between the price level and money supply. The quantity theory of money equation is $\text{MV = PY}$.

Money supply: Money supply refers to the total amount of monetary assets circulating in an economy during a particular period of time.