Equation of Exchange & Inflation Rate

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  • 0:03 Inflation and Money Supply
  • 1:08 Equation of Exchange
  • 3:26 Inflation & Money Supply
  • 5:46 Lesson Summary
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Lesson Transcript
Instructor: Shawn Grimsley
Too much of anything can be bad, and too much money in the economy is no different. In this lesson, you'll learn about the equation of exchange and how it can be used to analyze the rate of inflation and its relationship to the money supply.

Inflation and Money Supply

Inflation is an important concept in economic analysis that has real world importance. In a nutshell, inflation is an increase in the general price level in an economy. A high rate of inflation can wreak havoc on an economy. If wages don't keep up with prices, for example, people can't buy as much. If people can't buy as much, businesses stop producing as many goods and services. If production slows, people get laid off, businesses shut down and personal and business debts are not paid.

While more than one factor contributes to inflation, such as the general level of aggregate supply and demand in the overall economy, today we're going to focus on money supply as a factor that influences inflation. Money supply is simply the total supply of money currently in the economy. Keep in mind that the money supply includes not only the bills and coins in your pocket, but also all the electronic balances in checking and savings accounts throughout the economy.

We can analyze the effect of money supply on inflation through the use of the equation of exchange. Let's take a look.

Equation of Exchange

The equation of exchange is an equation that shows us how money supply, the velocity of money, and price level relate to each other. The velocity of money refers to how fast money passes from one person to another through economic transactions (for example, buying and selling) over a period of time.

We can state the equation of exchange as:

M * V = P * Y

Let's parse the equation. M stands for the money supply, while V stands for the velocity of money. On the other side of our equation, P stands for the average price level in the economy, while Y is the real GDP of the economy. GDP is short for gross domestic product, which is the value of all the goods and services produced in a country during a specific period of time. Real GDP is GDP that is corrected to take inflation into account by using the prices of a base year. This way you can see how much growth is 'real' as opposed to just inflation making it look like the economy is growing. So the equation tells us that the money supply times the velocity of money equals the price level times real GDP.

In the real world, the calculation of the equation of exchange can be quite complex because economies are very complex. So we're going to simplify things by using a fictional island economy known as Economia to illustrate the principle behind the equation.

Let's say that our island paradise is populated by only 10 people who each have $25, for a total money supply of $250.00. Economia is a simple place for relaxing, not for the hustle and bustle of economic activity. Our island denizens only engage in one economic transaction a month: every islander gives one back massage each month to another islander for $25. Since money trades hands only once a month, the velocity of money is 1. The price level is the cost of the massage, $25, and GDP is the number of massages given during the month, which is one per person or 10 massages. Let's plug in the numbers:

M * V = P * Y

$250 x 1 = $25 x 10 $250 = $250

Inflation & Money Supply

Through some mathematical manipulation, the equation of exchange can be rewritten to show the relationship between the variables in terms of the percentage rate of change of each variable. The equation looks like this:


Equation


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