Question

According to Irving Fisher equation, when velocity of money and output are fixed, the monetary authority can control inflation rate through controlling money supply(monetary policy) . What does the quantity theory imply for the monetary policy in an economy with unstable velocity? Explain factors that might make velocity of money unstable and unpredictable?

Answer 1

The Irving Fisher equation of exchange is MV = PY where M is money supply, V is velocity of money, P is price level and Y is real GDP.

Now when V and Y are constant then change in money supply is responsible for change in price level.

Unstable velocity of money means the number of times money is changing hands is continuously changing. So, it is now difficult to have a monetary policy to control inflation. It is so because change in money supply will not always result in desired change in price level because of changing velocity of money, as per the quantity theory of money shown by Irving Fisher equation.

The factors that would make velocity of money unstable are unstable inflation rate, fluctuating nominal GDP, and frequently changing money supply in the economy.