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

2. 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

3. 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
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4. 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”

5. 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 ↑

6. 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

7. Example: Equation of Exchange
MV = PY
Economy: M = $50 V = ? P = $ Y = 100 pizzas
Calculate Velocity:
Velocity = [ 50 * ___ = * $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 ↑

8. 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)

9. 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↑

10. Quantiy Theory of $ Handout