QTM Prof. Landskroner 1 Prof. Yoram Landskroner MONEY, OUTPUT AND PRICES

QTM Prof. Landskroner 2 QUANTITY THEORY OF MONEY F Hypothesizes relation between money, the general price level and aggregate output in the economy F Where the most common measure of aggregate output is the Gross Domestic Output (GDP):the value of all final goods and services produced in the economy during a year F Measures of general price level:  GDP price deflator = nominal GDP divided by real GDP  Consumer Price index (CPI): weighted average price of a “basket” of goods and services bought by a typical urban household

QTM Prof. Landskroner 3 F Real versus Nominal terms:  Nominal: values measured in current prices,nominal GDP  Real: constant or beginning of year prices, real GDP, measure of quantities of goods and services  The difference between the two is the change in the price level

QTM Prof. Landskroner 4 F The starting point (Fisher 1911) the relationship between money supply (quantity of money) M and value of spending on goods and services during a year:  P*Y Where P = General price level Y = Real output of goods and services (quantity) PY is therefore nominal output (nominal GDP)

QTM Prof. Landskroner 5 F The link between the two is the Velocity of Money, V:  V is the velocity of money,the rate of turnover of money We can now establish the exchange equation: F M*V = P*Y This is tautology: Value of money expensed on goods and services during a year equals the value of goods and services when purchased

QTM Prof. Landskroner 6 Early/Classical QTM F To convert identity to theory of the determination of nominal output, have to explain the determination of  velocity (institutional arrangements in the economy) and  money supply (central and commercial banks) F Early/Classical QTM: Assumes:  1. V is constant in the short run  2. V is independent of M  3. Y is at full employment

QTM Prof. Landskroner 7 Results and implications: F Changes in nominal output are determined solely by changes in the money supply F There is a proportional relationship between money and prices: M = (Y/V) P Where (Y/V) is a constant. F Thus an increase in money (quantity) supply is the only cause for an increase in the price level (inflation)

QTM Prof. Landskroner 8 F Because the model relates money and aggregate output it can also be taken to be a theory for the demand for money: M= k*PY Where k=1/V is a constant This is also known as the Cambridge equation F The demand for money is determined by the transactions generated by nominal output

QTM Prof. Landskroner 9 Modern QTM Following data collected after WWII assumptions of the old QTM were relaxed: F 1. V may vary even in the short run (it declined sharply during the Great Depression) F 2. Changes in M induce changes in V in the opposite direction F 3. Assumption of full employment may be unrealistic (Y < Y*)

QTM Prof. Landskroner 10 Implications and issues: F An increase in M may cause an increase in Y and/or P or a decline in V F Issue of speed of adjustments of aggregates to changes in M (P vs. Y) F Increase in M increases expenditure (MV) or nominal product (PY)?

QTM Prof. Landskroner 11 F Is velocity constant or can the QTM be used to predict inflation? F M2 velocity remained stable in the 1980’s F This lead the Federal Reserve to use the QTM to predict inflation F In the early 1990’s M2 growth declined but it settled down again in the late 1990’s THE END