The equation of exchange is an economic theory that shows the effect that the amount of money within a society has on price levels. According to the equation, the amount of money is multiplied by the velocity with which it is spent to equal the amount of spending. This part of the equation is equal to the price level multiplied by the amount of transactions. In general, the equation of exchange shows that more money within a society eventually causes inflation.
Economists are often concerned with the reasons that prices rise and fall within a specific society, and the effect that prices have on that society's overall economic health. Inflation can cause serious damage to the poorer members of society, so keeping price levels to a reasonable level is paramount. As more money is circulated throughout society, it tends to drive prices up. This is the basic tenet of the quantity theory of money, and the equation of exchange is designed to show how that occurs.
As an example of how the equation of exchange works, imagine that there are 50 units of money within a society. These 50 units are spent a total of five times in a given time period. The five times is the velocity in the equation, or V, and the 50 units is the monetary supply, or M. Multiplying M by V yields the amount of spending, which means, in this case, that the spending is 250 units, or five times 50.
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On the other side of the equation of exchange is the reaction of the producers in the economy. This part of the equation is price, or P, multiplied by transactions, or T. If the producers of goods set the average price at 25 units, that means that the amount of transactions would be reached by inverting the equation and dividing the spending of 250 units by 25, yielding a total of 10 transactions in that time period.
What the equation of exchange shows is that the price levels are directly affected by the amount of money in circulation. As more money is poured into society, producers can then react in kind by raising prices to keep up with increased demand for their products. Equilibrium will be achieved when the demand is satisfied and the monetary supply is exhausted. At that point, prices will begin to fall back down, creating a kind of circular pattern between buyers and sellers.