What does the Quantity Theory of Money equation (MV=PY) signify?

The Quantity Theory of Money is expressed through the equation MV = PY, where M represents the money supply, V is the velocity of money (the rate at which money circulates in the economy), P stands for the price level, and Y denotes real output or transactions in the economy.

This equation signifies that there is a direct relationship between the money supply and the overall price level and transactions in the economy. Specifically, when the money supply (M) increases, holding velocity (V) and real output (Y) constant, there is an increase in the price level (P). Conversely, if the money supply decreases, the opposite effect on the price level can occur. This relationship highlights that changes in the money supply indeed play a critical role in influencing both the price level and the amount of transactions occurring in the economy.

The correct answer illustrates the fundamental premise of this theory, which posits that the money supply is a primary driver of price levels and economic activity, hence making it vital for understanding inflation and economic dynamics. The other options misinterpret the relationship by either isolating effects to only one aspect of the economy or suggesting a lack of influence between transactions and price levels.