The Equation of Exchange

# The Equation of Exchange - The Equation of Exchange The...

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The Equation of Exchange The equation of exchange is an identity: . The equation of exchange can be interpreted in different ways: An identity stating that the money supply ( M ) times velocity ( V ) must be equal to the price level ( P ) times Real GDP ( Q ): . o (1) The money supply multiplied by velocity must equal the price level times Real GDP: . o (2) The money supply multiplied by velocity must equal GDP: . o (3) Total expenditures (measured by MV ) must equal the total sales revenues of business firms (measured by PQ ): . The equation of exchange is not a theory of the economy. However, the equation of exchange can be turned into a theory by making assumptions about some of the variables. For example, if we assume that both V and Q are constant, then we have the simple quantity theory of money, which predicts that changes in the money supply cause strictly proportional changes in the price level. A change in the money supply or a change in velocity will change aggregate demand and therefore lead to a shift in the

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