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Quantity Theory of Money (Explained)

Quantity Theory of Money (Explained)

18 Nov 2020

Reading Time: 3 minutes


Quantity Theory of Money states that money supply and price level in an economy are in direct proportion to one another. When there is a change in the supply of money, there is a proportional change in the price level and vice-versa. The most mainstream version of the Theory uses the Fischer Equation which is M*V=P*T.

In this equation,

M = Money Supply

= Velocity of Money

P = Price Level

= Volume of the Transactions

Although this is the most popular version of the theory, there are other variations of it. Those that are from the Keynesian and Monetarist school of economics. Quantity Theory of Money is an important part of the financial world. Most transactions and trends have become synonymous with this theory. It assumes that an increase in money supply creates inflation and vice versa. Supply and demand of a commodity influence the value. So, an increase in the supply of a commodity will decrease its marginal value and the buying capacity decreases.

The Quantity Theory of Money is part of traditional economics, where prices may be less volatile than crypto assets (although that is questionable, seeing as how cryptocurrencies like Bitcoin have become a sort safe haven asset). Trends in stock markets and crypto trends, while perhaps sometimes similar, diverge in many ways. So, using the Quantity Theory of Money in cryptocurrency markets may have its downfalls, but many argue that these disadvantages are also there in traditional financial system trends.

While it is the most long standing theorem of economics and changes in prices, it does have its problems. The most common one being the failure to post is an indirect relationship between money supply and price changes. The theory also presupposes that the factors are independent values of each other rather than a consequence of each other. An indirect relationship may be more appropriate for a financial world so volatile and unpredictable.

Nonetheless, it poses an important value to the crypto world, and a lot can be learned if we place cryptocurrency and blockchain technology in the framework of fiat currency and monetary economic theories. The concept of Bitcoin halving, where the reward given to miners is reduced to half the amount every 210,000 Bitcoins, or approx. 4 years. This is closely linked to this Quantity theory. By reducing the circulation of Bitcoin, it becomes more of a valuable asset. If we look at the halving events closely, we can see a trend where halvings have correlated with intense boom and bust cycles. Even when the price decreases after the initial boom, it has ended with higher prices than prior to the event. This artificial inflation and deflation creates a sort of high demand and low supply. This increases the value of Bitcoin.

So, the quantity theory of money may still be an important theory to look toward if we want to predict cryptocurrency trends. With such an uncertain and volatile market, some sort of certainty may still be welcomed in the crypto world.

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