Quantity Theory of Money

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Presentation transcript:

Quantity Theory of Money Why Money is Neutral!

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

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

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”

Example: Equation of Exchange MV = PY Economy: M = $50 Y = 100 pizzas P = $10 V = ? Calculate Velocity: Velocity = 20 [ 50 * ___ = 100 * $10 ] An ↑ quantity 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 velocity is constant

↑ Money Supply does not raise full potential. MV = PY An ↑ quantity of money must be reflected in one of 3 variables: The price level must rise (inflation) the real GDP must rise (more goods sold) or Or the velocity of money must fall ↑ Money Supply does not raise full potential. So, Price Level must rise!

Money is Neutral! If the Fed increases the quantity of money, it causes a proportionate change only in Nominal GDP (P  Y) Because MONEY IS NEUTRAL, money has no effect on Real GDP Why: money does not increase the “full potential” of an economy to produce goods/services MV = PY No shift of PPF when MS↑

Quantiy Theory of $ Handout