Final answer:
The quantity theory of money indicates the money supply determines the price level, which is articulated in the equation Money Supply X velocity = Nominal GDP = Price Level x Real GDP. The theory has significant implications for monetary policy, as evidenced by central banks' responses to velocity fluctuations.
Step-by-step explanation:
The quantity theory of money shows that the money supply determines the price level. This theory reflects the relationship between the amount of money in an economy and the level of prices of goods and services. This connection can be understood through the equation Money Supply X velocity = Nominal GDP = Price Level x Real GDP, which is sometimes referred to as the basic quantity equation of money.
Universal generalizations about the quantity theory of money tell us that changes in the money supply can significantly impact economic variables like interest rates, credit availability, and price levels. Therefore, both expansion and contraction of the money supply affect the cost of credit. Historically, the quantity theory has been an influential tool for fiscal policy, as evidenced by changes central banks made in response to fluctuating velocity in the 1980s.
Central banks have learned from experience with the quantity theory of money that a constant rate of money supply growth could cause nominal GDP to change unpredictably if the velocity of money is volatile. This understanding has led many to adjust monetary policy by considering current economic indicators like inflation and unemployment, rather than sticking rigidly to a predetermined money supply growth rate.