1. Quantity Theory of Money
Why Money is Neutral!

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. 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 ↑

4. 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

5. 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”

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

7. ↑ 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!

8. 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↑

9. Quantiy Theory of $ Handout