The quantity theory of money posits that money is neutral in the long-run, that is, money has no real effects on employment or income. The quantity theory of money was first developed in Classical economist David Hume’s (1752) paper ‘Of Money’ (Snowden et al 1994, p.56).
Let’s look at money demand (Md) and money supply (M). Money demand is determined by the need to buy goods and is thus positively related to aggregate expenditure so:
Md = kPY
Where Md is nominal money demand, k is the fraction of money (or aggregate money income PY) that agents wish to hold, P is the price level and Y is real output.
Money supply is exogenous and determined by the monetary authorities so:
M = Md
M = kPY
K is constant and, because of full employment, Y is also constant. So if the money supply increases, because k and Y are fixed, households have more money to spend on the same amount of goods and services so all that happens is the price level rises.
Alternatively, Fisher’s equation of exchange shows:
MV = PY
Where V is the velocity of money and reflects the average number of times a unit of money is used in the cause of conducting transactions, V is simply and is, like k, fixed.
Let’s start at the intersection of AD and AS at full employment equilibrium.