Can You Explain The Quantity Theory Of Prices?

Having defined an interesting new variable called velocity, we now describe how early monetary specialists used the concept of velocity to explain movements in the overall price level. The key assumption is that the velocity of money is relatively stable and predictable. The reason for stability, according to these economists, is that velocity mainly reflects underlying patterns in the timing of income and spending.

If people get paid once a month and tend to spend all their incomes evenly over the course of the month, income velocity will be 12 per year. Incomes could double prices might rise 20 percent, and total gross domestic product may be up many times yet with unchanged spending patterns the income velocity of money would remain unchanged. Only as people or businesses modify their spending patterns or the way they pay their bills does the velocity of income change.

On the basis of this insight about the relative stability of velocity, some early writers, particularly the classical economists, used velocity to explain changes in the price level. This approach, called the quantitative theory of money and prices.