Question

According to the quantity theory of money, i know that using more credit cards to carry out transaction would lead to an increase in velocity according to the equation V=PV/M since there would be a decrease in money supply. But my question is that doesnt velocity show how many times a dollar is spent purchasing finished goods and services thus an a decrease in money supply should lead to decrease in velocity? I am confused please answer my question in detail thank you!!!

Answer 1

A decrease in money supply would mean that there is less money in the economy available to purchase goods and services. To maintain equilibrium, the money has to change hands more often to purchase same amount of goods as before.

Example:

Suppose price equals to 1. There are 100 units of goods in the economy and money supply is 100. So there is total of $100 to buy $100 worth of goods.

Equation V = PV/M = 100/100 = 1

Now suppose money supply falls to $80

Now V = PV/M = 100/80 = 1.25

Since, there is now less money in the economy, a dollar will circulate more in the economy so that the same value of goods are purchased. Here when the money supply falls to $80, the velocity increases so that PV=$100 worth of goods are purchased.

Hope this helps.