Quantity theory of money (QTM) – suggests that the demand for real money balances is
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proportional to income.
Quantity eqn.:
MxV=PxT
where M – money supply;
V – velocity of money: the # of times a PhP bill changes hands for time, t;
P – price level; and,
T – transactions.

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Income (Y) version of the QE:
MxV=PxY
◦ where V: the # of times a PhP bill enters someone’s income; ◦ P x Y: nominal GDP.

This version of the QTM is used since it is difficult to observe transactions.

Money Demand & the Quantity Theory of
Money:
 uses real money balances to measure the purchasing power of the stock of money;
 the money demand function is like the demand function for a particular good, i.e. the convenience of holding real money balances; 2

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Money demand function below shows that the quantity of real money balances demanded is proportional to real income;
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M
P

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D

 kY

There is an inverse relationship between V & k:
M x V = P x Y if
V=1/k
This implies that when:
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(M/P)D is high, k is large, V is small: money changes hands less; OR,
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(M/P)D is low, k is small, V is large: money changes hands more.

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Velocity (V) & the QTM: M x V = P x Y
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If V, is assumed to be constant, QTM explains what determines nominal GDP;
A change in M leads to a change in nominal GDP, thus, if V is fixed, the quantity of money determines the Peso value of the economy’s output; In reality, the velocity of money, V, does change.
◦ The advent of ATMs and E-cash has resulted in
↓(M/P)D → ↓k → ↑V.

Three building blocks of what determines the economy’s overall level of prices:
1.
Real GDP – determined by the productive capacity of the economy, i.e. factors of production & production function;
2.
Nominal GDP – determined