Monetary Exchange Equation Relates Money Supply to Inflation

You can use the monetary exchange equation to explain the relationship between the supply of money and inflation, as follows:

Velocity x Money Supply = Gross Domestic Product (GDP) x GDP Deflator.

Velocity is a measure of how fast money is changing hands, recording how many times per year the money actually is exchanged. GDP is the sum of all the goods and services produced by the economy. The GDP deflator is a measure of inflation, or a sustained rise in prices.

Here’s what’s important about the money supply as it relates to futures and options trading: A rising money supply, usually spawned by lower interest rates, tends to spur the economy and eventually fuels demand for commodities.

Whenever the money supply rises to a key level, which differs in every cycle, inflationary pressures eventually begin to appear, and the Federal Reserve starts reducing the money supply. The more money that’s available, the more likely that some of it will make its way into the futures and options markets.