Equation of Exchange

It is one of the oldest formal relationships found in early economics in the 17th century and used to express the classical theory of inflation.

In the classical books, there was a strong distinction between the variables measured in the dollar and those in physical terms.  The equation can be used as an indicator of the demand for money in a macroeconomic model. 

It states M x V = P x Q where M represents the money economy for the given period, V is the velocity (the avg. number of times a dollar is spent on buying goods in the year), P represents the weighted average of the cost of all the transactions and Q is the real output (calculate real GDP). 

The main use of the expression is in estimating the market value of goods manufactured and the changing patterns of commodity production and consumption where one finds the change in money supplies changes the price level.

It can be used for the classification of analyzing the forces behind the money economy or the theory that works as a building block for the Quantity Theory of Money.

It can be explained as below - People use the money to buy goods or they save it in a bank. If the money is put in banks the lenders can give more and attract new borrowers, which in turn, can lead to higher spending on houses and cars, and the increase in demand will then lead to price rise.