Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Quantity Theory of Money

What it is:

The quantity theory of money argues that the size of the money supply influences the price of goods.

How it works (Example):

The quantity theory of money (sometimes called QTM) says that prices rise when there is more money in an economy and they fall when there is less money in an economy. The following formula expresses the theory:

M x V = P x T

Where M = the money supply
    V = the velocity of money
    P = average prices
    T = number of transactions in the economy

Economist Henry Thornton is credited with developing the theory in 1802 after noticing that the more gold and silver Europe imported in the 16th century, the more things cost.

Why it Matters:

The quantity theory of money revolves around the basic idea that the more money people have, the more they spend, and when more people are competing for the same goods and services, they essentially bid the prices up for those things. This is the core of monetary theory. Accordingly, when employment rates increase or the government cuts tax rates, people suddenly have more money to spend. This, when not done in moderation, can create runaway inflation.

Though it may seem that having more money to spend means people are "richer," it is important to note that the increase in money supply means rent, groceries, gas, cars, and college tuitions increase in price too, offsetting the effects of having more money. In short, the amount of money in an economy determines the value of the money in the economy.