What theory posits that excessive money supply in the economy leads to inflation?

The quantity theory is rooted in the idea that the amount of money in circulation directly impacts the overall price levels in an economy. This theory, often summarized by the equation MV = PQ, where M is money supply, V is velocity of money, P is price level, and Q is output, suggests that if the money supply increases faster than the economy's ability to produce goods and services, it will result in inflation. Essentially, when more money chases the same amount of goods, prices rise.

Understanding this theory is crucial because it illustrates the relationship between monetary policy and inflation, highlighting the importance of controlling the money supply to maintain price stability. In contrast to other theories, such as the demand-pull theory, which focuses primarily on consumer demand driving prices up, or the cost-push theory, which sees rising costs of production as a key factor in inflating prices, the quantity theory presents a more direct link between money supply and inflation, making it a foundational concept in monetary economics.