1 Quantity Theory of Money

2 Overview You may recall we said two things about RGDP earlier this term. 1. Over the long term RGDP has risen. 2. In the short term RGDP fluctuates. In this section we want to consider another long term phenomenon. The point we want to make is that inflation in the long term is a monetary thing. Lets explore some ideas to see this. By the way, folks who are up on the ideas we consider here are often called monetarists and Milton Friedman was one of the leading thinkers in this area.

3 What does the word velocity mean to you? One context is that it is the speed at which we can travel in a car. Tell me the answer to the following question. IF you consider driving around a track, what happens to the number of times you can go around the track IN ONE HOUR, the higher your velocity? The higher your velocity the more times you can go around the track. Now, try this one. If you want to take only 100 laps, what happens to the time it takes you to travel 100 laps the higher your velocity? Excellent – the higher the velocity the less time it takes to do 100 laps. What does this have to do with economics?

4 Consider the equation know as the Quantity Equation, M V = P Q (You would read this as MV equals PQ and it means M times V equals P times Q). M stands for the money supply, like M1. P stands for the GDP deflator, you know, that one price index. Q stands for RGDP. V stands for velocity of money. What the heck is velocity of money? V = (P Q)/M, this helps, right? Well P Q is basically telling us about GDP, the output of goods and services in dollar terms. M is the money supply. If the GDP is a certain amount, the less money there is the quicker the money must circulate through the economy.

5 So V is just how quickly our money moves through the economy. It is true that the money supply M1 is less than the GDP. How do we accomplish this? The dollars pass from consumer to producer to consumer over and over again in the economy. How many times in a year the dollar moves from consumer to producer is the velocity of money. The velocity is somewhat stable, meaning it doesnt change a whole lot from year to year. The reason for this has to do with our habits of spending and how often we get paid, and other things we need not worry about here. Also remember that we said a while back that RGDP changes in the long term because of technology, natural resources, capital and labor amounts and the like.

6 Now I will rewrite the quantity equation, but a tad different. M V = P Q I put a bar over the V and the Q. I did this to have you say to yourself that if velocity is relatively stable in the long run and if RGDP is only influenced in the long run by the technology and resources we have, then movements in money can only change the price level. As a mechanical example, assume V = 1 and Y = 100. Then if M = 10, P = 0.1 and if M = 20, P = 0.2. This story is used to highlight the idea that inflation in the long run is a monetary phenomenon. The higher the money supply the higher the price level.