Download The Quantity Theory of Money

The Quantity Theory of Money
The quantity theory
predicts that changes in the
quantity of money affects
only prices—not real GDP
and employment. We call
this the “money neutrality”
theorem.
The Equation of Exchange
M V  P Y
Where
•M is the quantity of money
•V is the velocity of circulation
•P is the price level
•Y is real GDP
What is velocity (V)?
Velocity (V) is the average number of
times per year a unit of money is spent for
new goods and services. Let
V  (P Y )  M
(P  Y) is nominal GDP. Let P = 1.25; Y = $8
trillion; and M= $2 trillion. Thus:
V  (1.25  $8 trillion)  $2 trillion
Or, V = 5
Equation of Exchange is
Always True
The equation simply states
that what is spent for new
goods and services (M  V)
is equal to the market value
of new goods and services
produced (P  Y).
Illustration
Using the numbers on a preceding slide, we can see
that
P Y  $1.25 $8 trillion  $10 trillion
and
M V  $2 trillion  5  $10 trillion
thus
M V  P Y  $10 trillion
“Monetarist” interpretation of
the equation of exchange
The monetarists believe
that price level changes
(hence inflation) can be
explained by changes in
quantity of money
“Inflation is always and
everywhere a monetary
phenomenon.”
Example
Assume that V = 5
and is constant. Y is
$8 trillion (also
assumed to be
constant). Initially,
let M = $2 trillion
Our basic equation can be rearranged as follows:
P  M V  Y
Now solve for the price level (P):
P  $2 trillion  5  $8 trillion  1.25
Now let the money supply increase to $2.4 trillion.
Notice that:
($2.4 trillion - $2 trillion) 100  $2 trillion  20 percent
Thus we have:
P  $2.4 trillion  5  $8 trillion  1.50
Notice that:
(1.5 - 1.25) 100  1.25  20 percent
Hence a 20 percent
increase in the money
supply causes the price
level to increase by 20
percent. Monetarists put
the blame for inflation
squarely at the doorstep
of the monetary
authorities (in the U.S.,
the FED).
First differences of Nominal GDP and M2
Source: Federal Reserve Board
M2 is lagged one year
500
450
400
350
300
250
200
150
100
Nominal GDP
50
0
60
M2
65
70
75
80
Year
85
90
95