Two of the most important pillars of classical economics theory

are CA's Law and the quantity theory of money.

In our last module,

we learned how CA's law helps us think about

the determination of aggregate supply and aggregate demand,

and why, at least according to CA's law,

supply and demand should always tend towards equilibrium.

In this module, we take on the quantity theory of money.

In a classical economics framework,

this quantity theory of money is very useful in determining the rate of inflation.

That is the price level.

This theory will also be quite useful when we talk about

monetary policy in

a future lesson.

The quantity theory of money is based on the so-called equation of exchange.

This equation may be written as M × V =

P × Q. M of course equals the money supply.

V is the velocity of money or

the amount of income generated each year by a dollar of money.

P is the general price level as measured by an index such as

the consumer price index and Q is

the quantity of real inflation adjusted output that is sold.

That is; that's a nation's real inflation adjusted GDP.

Please also note that P × Q is the nominal output or GDP of the economy.

While changes in the price level measure the rate

of inflation or deflation in an economy.

In its simplest terms,

the quantity theory of money says that the price level

varies in response to changes in the quantity of money.

The money supply rises, so will prices.

And that's called inflation.

In contrast, if the money supply falls, prices will fall.

And in this key definition,

when the price level falls, that's called deflation.

In fact, from this strict relationship between the money supply and the price level,

classical economists come to

a very important conclusion about how effective monetary policy.

Example, increasing the money supply M might be at stimulating growth in the real GDP.

So, what do you think that conclusion is?

Be committed now to jot down an answer before moving on.

In fact,

classical economists conclude from the quantity theory of

money relationship that discretionary monetary policy for example,

printing more money to stimulate growth in the real GDP won't be effective at all.

Indeed it shouldn't even be attempted because all it will do is create inflation.

In fact that's a very pessimistic view about expansionary monetary policy which

in today's modern times is regularly used to stimulate real GDP growth.

So, what exactly is going on here?

Well, the classical belief that printing more money only causes inflation

follows from two additional and quite restrictive assumptions

that the classical economists make.

Namely, that the velocity of money V is constant and that money is merely availed.