Objectives:
* The quantity theory of Money
 

THE QUANTITY THEORY OF MONEY
MV = PQ         

Where
M= Money Supply

V = Velocity of money (the number of times it is circulated).

P = Price (the price level in the economy).

Q = Quantity (output in the economy).

The CRUDE quantity theory of money assumes the velocity of money (the number of times money is used in a given period) and quantity are constant.

So if we assume the velocity of money and output to be constant then any change in the money supply will have an effect on PRICE.
But as we can see in the graph below – output is not constant and fluctuates over time. This means that the assumption that Q or output remains constant is a weakness.

The SOPHISTICATED Quantity Theory of Money assumes that only the velocity of circulation (V) is held constant.
This means that any change in the money supply (M) will affect either the price level (P), output (Q), or both..

Here a change in the money supply (M) will result in a change to PQ. What is not clear is whether P or Q will change or both will change.

The effect of a change in the money supply will depend upon how close to full capacity (or full employment) an economy is.
e.g.

When an economy is not near full capacity there are a lot of unemployed resources / technology and so if the money supply increases (M) this can be absorbed by increases in output and the average price level (inflation) does not increase by as much.
or
When an economy is near full capacity all resources and technology are being fully utilized and so an increase in the money supply (M) will cause a lot of inflation because output is not able to increase by much causing the average price level to increase.

THE BUSINESS CYCLE
The economy changes over time and tends to follow a cyclical pattern. At time the economy is doing well as economic activity and levels of employment increase. At other times the economy slows down and output and employment decrease.

When the economy is in a boom any increase in the money supply (M) will become more inflationary as output (Q)  reaches full capacity.
After the economy peaks (boom) then economic activity will begin to decline (a downturn / recession). Resources become more available as output falls and unemployment rises. A rise in the money supply (M) may be less inflationary as output is now more easily able to increase.