What is the essence of the "quantity theory of money"?

The essence of the "quantity theory of money" is that it establishes a direct relationship between the amount of money in circulation and the overall price levels in an economy. This theory, which can be summarized by the equation MV = PY (where M is money supply, V is velocity of money, P is price level, and Y is real output), posits that if the money supply increases, holding velocity and output constant, prices will tend to rise.

This foundational concept implies that changes in the money supply can have significant effects on inflation and economic activity. When there is more money circulating in the economy without a corresponding increase in the production of goods and services, it generally leads to higher prices. Conversely, a decrease in money supply without changes in production can lead to deflation.

Understanding this relationship is crucial for macroeconomic policy, especially in managing inflation and economic growth. Therefore, the link between money in circulation and price levels is paramount in the context of this theory.