The Equation of Exchange, MV = PQ, describes the relationship between money supply, velocity, price level, and real output. Irving Fisher made this equation famous, representing the product of money supply and velocity as equal to the product of price level and quantity of output.
- The monetary equation of exchange that economists use to explain the relationship among money supply, price level, and real output is known as the Equation of Exchange.
- This equation is typically expressed in the form MV = PQ, where M represents the money supply, V is the velocity of money, P signifies the price level, and Q is the quantity of goods and services produced (real output).
- According to Irving Fisher, who made this concept famous, the equation states that the product of the money supply and the velocity of money equals the product of the price level and the quantity of output.
- To understand how this works, consider an economy with a fixed money supply.
- If the velocity of money remains constant, any increase in the price level (inflation) must be accompanied by a corresponding decrease in the quantity of output, or vice versa.
- In other words, more money chasing the same amount of goods will result in higher prices.
- Conversely, if the money supply increases without a change in the velocity of money or in the quantity of output, the price level must rise to maintain the equality.