5.3 Money Growth and Inflation

The equation of exchange, M × V = P × Y, links the money supply (M) and the velocity of money (V, how often a dollar is spent per year) to the price level (P) and real output (Y). The quantity theory assumes velocity is stable and real output is pinned at potential in the long run.

With V and Y fixed, any sustained growth in M must show up as growth in P — inflation. This is why economists say sustained inflation is ultimately a monetary phenomenon, and why hyperinflations trace back to governments printing money to cover spending.

This is money neutrality: in the long run, changes in the money supply affect nominal variables (the price level, nominal wages) but not real variables (real GDP, employment, the real interest rate). The short-run boost from monetary expansion evaporates as prices and expectations adjust.