Here are the main assumptions of the Quantity Theory of Money:
- Money is a Neutral Medium of Exchange: The theory assumes that money acts solely as a medium of exchange and does not have any real effects on the economy other than facilitating transactions. In other words, changes in the quantity of money do not affect real variables like output, employment, or productivity in the long run.
- Velocity of Money is Stable: The theory assumes that the velocity of money, which represents the average number of times a unit of money is spent in a given period, is relatively stable over time. It implies that people’s spending habits and the frequency of transactions do not fluctuate significantly.
- Full Employment: The theory assumes that the economy operates at full employment, meaning that all available resources are fully utilized, and there is no involuntary unemployment. This assumption implies that changes in the quantity of money only affect prices and do not have any impact on employment or output levels.
- Money Supply is Exogenously Determined: The Quantity Theory of Money assumes that the money supply is determined externally and is not influenced by other economic variables. It views the central bank as the sole authority responsible for controlling the money supply and assumes that it adjusts the money stock according to its monetary policy objectives.
- Demand for Money is Proportional to Income: The theory assumes that the demand for money is directly proportional to the level of income in the economy. As income increases, individuals and businesses require more money to facilitate their transactions.
- Long-Run Equilibrium: The Quantity Theory of Money focuses on long-run equilibrium in the economy. It assumes that in the long run, changes in the money supply will only lead to changes in the price level, while real variables such as output and employment will remain unchanged.
- It’s important to note that while the Quantity Theory of Money provides insights into the relationship between money supply and prices, it has been subject to various critiques and is not universally accepted as a complete explanation of inflation dynamics. Economists often incorporate additional factors and models to analyze the complexities of monetary phenomena.
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