Equation of Exchange Definition
The equation of exchange refers to an economic equation that establishes the link or relationship between velocity of money, money supply, index of expenditures, and the average price level. John Stuart Mill came up with this equation that was inspired from David Hume’s thoughts. The equation of exchange is:
M*v = P*T
Here, M stands for money supply,
V stands for velocity of money,
P stands for the average price level of goods,
T stands for index of expenditures
A Little More on What is Equation of Exchange
The equation of exchange has two major benefits to offer. It is based on the quantity theory of money’s main principle that says, the increase in the money supply will lead to an increase in the overall prices. Also, if we find the value for M as per the equation, it can give insights about the demand for money.
The equation of exchange can further provide information about how the variables included in the equation can help in knowing the status of the economy. With the help of equation, economists can find out the impact of the money supply on the price level of goods. The central bank of a nation formulates money supply, and decides on whether to increase or decrease these variables with regards to the commercial operations. Monetarist economic theories follow the similar approach saying that the relationship between the price of goods and money supply is a true indicator of an economy’s performance. However, it is contrary to Keynesian theory that says the economic condition of a nation gets indirectly affected by the influence that money supply creates on rates of interest, and ultimately, the payroll levels.
How the Equation of Exchange is used for Economic Forecasts
As per the equation, if the variables including the index of expenditure and the velocity of money don’t change over time, then the increase in the money supply will result in an increase in the average price levels, and vice-versa. This means that both money supply and average price levels will have a direct relationship.
The variable T given in the equation is also denoted by Y, Q, or other initials sometimes. This variable exhibits several factors such as industrial production that are associated with the final output of the economy. Also, one can calculate the average price level of goods by dividing gross domestic product with real GDP. Money supply, when multiplied with the velocity of money, results in ascertaining the nominal GDP.
Owing to the weak conditions or economic scenario of a country, there can be cases when the variables mentioned in the equation of exchange can experience a decline irrespective of what the equation actually predicts.