The link between transactions and money is expressed in the following equation, called the quantity equation:
Money ×Velocity = Price × Transaction
M × V = P × T
A money demand function is an equation that shows the determinants of the quantity of real money balances people wish to hold. A simple money demand function is:
(M/P)^d = kY
“The quantity theory of money states that the central bank, which controls the money supply, has ultimate control over the rate of inflation. If the central bank keeps the money supply stable, the price level will be stable. If the central bank increases the money supply rapidly, the price level will rise rapidly.”.
The revenue raised by the printing of money is called seigniorage. The term comes from seigneur, the French word for “feudal lord.” In the Middle Ages, the lord had the exclusive right on his manor to coin money. Today this right belongs to the central government, and it is one source of revenue.
When the government prints money to finance expenditure, it increases the money supply. The increase in the money supply, in turn, causes inflation. Printing money to raise revenue is like imposing an inflation tax.