The quantity theory of money states that a reduction in the quantity of money in circulation would bring about

Analyze the question The question asks what the quantity theory of money predicts when the quantity of money in circulation falls.

Explain the concept The quantity theory is expressed by Fisher's equation of exchange:

MV = PT

• M = quantity of money in circulation
• V = velocity of circulation (how often money changes hands)
• P = price level
• T = volume of transactions (or output)

The theory assumes that V and T are constant (the economy is at full employment, and spending habits do not change quickly). Under these assumptions, P depends directly and proportionately on M:

P = MV / T

Step-by-step solution

1. Start with MV = PT, with V and T held constant.
2. If M falls, for example by 20%, the left side falls by 20%.
3. For the equation to balance, P must also fall by 20%.
4. So a reduction in money supply leads to a proportionate fall in the price level.

Checking the options

• A. A constant change in price: wrong. Prices do not change by a fixed amount, they change in proportion to M.
• B. A rise in prices: wrong. This would follow an increase in money supply.
• C. An unequal fall in prices: wrong. The theory says the fall is equal (proportionate), not unequal.
• D. A proportionate fall in price: correct.

Tip Remember: "Money and prices move together, in the same direction and by the same proportion." If M goes up, P goes up proportionately. If M goes down, P goes down proportionately. Always remember the assumption that V and T are constant, as JAMB often tests it.