The Quantity Theory and the Price Level

The classical economists believed that the supply of money would determine the price level. To see how that would work, we can rearrange the "quantity equation,"

M*V = p*RGDP

And get

p = M*V/RDGP

If the money supply is given, then, according to the rearranged quantity equation, the price level depends on production and the "velocity" constant. In turn, many classical economists treated RGDP as a constant, on the following reasoning:

• They assumed that the employment of labor would be determined by the supply and demand for labor, along with the wage in purchasing power terms.
• The employment of labor, together with the productivity of labor, would determine production as measured by RGDP.
• Since since the supply and demand and productivity of labor are al independent of the price level and the quantity and velocity of money, production would also be independent of those things, that is, a constant so far as the quantity equation is concerned.

This is illustrated with a diagram on the next page:

A Diagram