refers to what is known as the equation of exchange, which describes how factors, such as the amount of money in circulation and velocity of money, are directly related to the prices of goods and services.
How the Money Equation Works
The term "money equation" can refer to many different equations used in finance. The equation of exchange is one of them. This money equation is the basis of financial analysis, and the one companies use the most often. The equation is based on the quantity theory of money. In simple terms, the theory states that the inflation or deflation in prices for goods and services correlates with the amount and supply of money in an economy. Experts have used the equation of exchange to support the thought that monetary inflation occurs in a predictable pattern.
We write the equation of exchange as M ⨉ V = P ⨉ T.
- Here, M is the supply of money, which is simply the average amount of money in circulation during a given year.
- V is the velocity of money. The average number of times that the currency unit is observed is traded during that same year.
- On the other side of the equation, P represents the price level, which is the average price of all goods produced by an economy during the year in question.
- T is the total expenditure or the actual amount of money spent in the economy over the year.
Of particular interest with the equation of exchange is the variable M: the money supply. One of the main reasons for this is because the money supply during a given year is one of the only factors in this equation that someone can deliberately manipulate. And the government does deliberately manipulate this factor, mainly by printing money and, therefore, adding to the money supply. The government manipulates the economy's money supply with great care as too much or too little interference could lead to damaging economic repercussions.
Example of the Money Equation
Normally the money equation (equation of exchange) is used when estimating the rate of inflation over two or more years/periods of time. The periods that someone studies are most likely historical, as most of the factors considered in the money equation are observed rather than predicted. For this example, however, we're going to use the equation to analyze a single year with smaller values that are easier to comprehend.
In this scenario, the velocity of money, V, is 3.5 (so, in this case, each dollar changes hands, on average, 3.5 times during the studied period time), the price level, P, is $380.34, and the total expenditure, T, is $23,202.74. When this is all plugged into the money equation, it should look like M ⨉ 3.5 = 380.34 ⨉ 23,202.74 with only M as an unknown variable.
After multiplying the values and then dividing, the money supply, M, would be found to be $2,521,408.61. The average amount of money in circulation over the period was just over $2.5 million.