The Equation of Exchange & Money Neutrality Monetarist Economics The Equation of Exchange & Money Neutrality

Quantity Theory of Money What: Monetarist Theory which states the quantity of money determines the value of money (price level) i.e. the primary cause of inflation is the growth of money supply Implication: In long run, ↑ MS has no effect on real GDP ↑ MS only raises price level “Inflation is always and everywhere a monetary phenomenon” Milton Friedman Leading Monetarist Economist

Monetarist Economics It only creates inflation! Potential GDP Monetarists believe printing money does NOT change full potential GDP A B C D E Actual and Potential GDP Actual GDP It only creates inflation! Monetarists do NOT support active monetary policy to adjust business cycle Time Copyright © 2003 South-Western/Thomson Publishing. All rights reserved.

Equation of Exchange V = (P  Y)/M MV = PY P = Price level where: V = Velocity P = Price level Y = Real GDP M = Money Supply Re-write Equation MV = PY Known as: “Equation of Exchange”

Velocity of Money The velocity of money is the number of times the average dollar bill is spent in a year it has been relatively stable since 1960 Monetarists assume velocity is stable Determinants of velocity: Efficiency of the payments system Efficiency ↑ => Hold less money => Velocity ↑

Stability of the Velocity of Money Indexes Stability of the Velocity of Money (1960 = 100) 2,000 Nominal GDP M2 1,500 1,000 500 Velocity 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

Example: Equation of Exchange MV = PY Economy: M = $50 V = ? P = $10 Y = 100 pizzas Calculate Velocity: Velocity = 20 [ 50 * ___ = 100 * $10 ] An ↑ M (qty of money) must be reflected in one of 3 variables: price level must rise (inflation) real GDP must rise (more goods sold) or velocity of money must fall But if velocity is constant, only inflation would ↑

Monetarist Economists Monetarists believe Velocity (V) is constant which means an increase in MS only raises price level MV = PY If M ↑ 20% & Velocity (V) is constant => Price Level (P) ↑ 20% Real GDP (Y) is unchanged & Nominal GDP ↑ 20% (PY)

Monetarist Conclusion Monetarists believe MONEY IS NEUTRAL so MS has no effect on Real GDP money does not increase the “full potential” of an economy to produce goods/services Monetarists believe if the Fed ↑ MS, it causes a proportionate change in Nominal GDP (P  Y) & no change in Real GDP MV = PY No shift of PPF when MS↑

Quantiy Theory of $ Handout