Equation of Exchange
The equation of Exchange is always related to the demand, supply, and velocity of money. It gives an idea about the money which is demanded and supplied in a country. It is a powerful index in deriving the inflow and outflow of cash.
The theory was first propounded by Economist John Stuart Mill.
However, there are procedures by which Equation of Exchange can be derived. Along with many other factors like demand and supply prices and expenditure also plays a vital role in deriving Equation of Exchange. To get Equation of Exchange the formula is:
MS x VM = APP x NE (in fig.)
MS stands for Money Supply
VM stands for Velocity of money
APP stands for Average Price of products and
NE stands for Number of expenditure i.e. Output
Study of Equation of Exchange shows the demand and supply of money. If there is too much of money supply it will lead to the general rise of prices in the economy.
While studying Equation of Exchange generally the Velocity and the Output is constant. In all forms, whether it’s Keynesian Theory or Classical Approach the velocity of money in the short run is constant. Also, the output is not subjected to too many changes. Thus the Velocity and the Output are kept constant while deriving Equation of Exchange.
The equation of Exchange gives us an idea about the relation between the prices and the money supply. If the supply of money is changed marginally then the prices will also change marginally, keeping Velocity and Expenditure constant.
There persists a strong relationship between Money Supply and Price. This Equation of Exchange development proved very useful for understanding the relationship between Money Supply and Price level. However keeping Velocity and Expenditure constant is not practical and hence it was critically acclaimed as well. But the formula proved to be very useful for understanding the economy’s supply of money.