Explanation

• According to the classical money theory, money is purely nominal. That is, changes in money supply will have only affect the price levels, but not the real output. Specifically, according to the quantity theory of money, we have:
• real output * price level = money supply * money velocity
• Holding money velocity constant, a reduction in money supply will reduce the price level proportionately, but has no effect on real output.
• Quantity Theory of Money: The quantity theory of money states that the product of real output and price level is equal to the product of money supply and money velocity. This theory is based on a simple equilibrium condition for the money market.