EQUATION OF EXCHANGE
The Equation of Exchange addresses the relationship between money and price level, and between money and nominal GDP.
The equation simply states: M x V = P x Y
Where M = the money supply, usually the M1
V = the velocity of money
P = the price level
Y = real output, or real GDP.
Velocity is the number of times the average dollar is spent to buy final goods and services in a given year. Velocity can be calculated by using V = (P x Y ) / M
The equation tells us that total spending (M x V) is equal to total sales revenue (P x Y). Since (P x Y) is equal to the nominal GDP, then M x V = nominal GDP.
Velocity (V) and Real GDP (Y) are effectively constant in the short run, therefore any changes in money supply (M), will cause a proportional change in the price level (P).
Re-writing the equation, we get: P = ( M x V ) / Y
This equation demonstrated a direct relationship between price and money supply. If V and Y are constant, a certain percentage change in money supply will cause a same amount of change in the price level.