Sample Solution

However, another school of economic theory called the monetarism, argues that the money supply is the only one factor that can determine the price levels in an economy and that the only government intervention possible is to manage the growth rate of money supply in order to match it with the growth rate of the output in the long run.

The foundation of monetarism is the Quantity Theory of Money. The theory says that the money supply in the market multiplied by the velocity (how fast the changes hands) is equals to the nominal expenditures in the economy (the number of goods and services sold multiplied by the average price paid for them). This equation is uncontroversial because it is an accounting identity. However, the velocity is controversial. Indeed, the monetarist theory views the velocity as something that is supposedly stable, so that means that the nominal income is a function of the money supply. Milton Friedman admitted that the velocity might vary a little but not really much so it can be treated as fixed

Furthermore, variations in the nominal income will reflect a change in real economic activity (how many goods or services are sold) and will also create inflation.

Let’s explain the idea with an example. The formula is MV=PT.

If the total money supply is initially $1000 and the velocity of circulation is 5.

Then MV=1000×5,

Furthermore the level of output (Y) is 5000 units.

So, $1000×5 = P (5000), therefore P = 1