This chapter introduces the quantity theory of money to explain one of the Ten Principles of
Economics from Chapter 1:
Prices rise when the government prints too much money.
Most economists believe the quantity theory is a good explanation of the long run behaviour of
The Classical Theory of Inflation
Inflation is an increase in the overall level of prices.
Hyperinflation is an extraordinarily high rate of inflation.
Countries can collaspe
Inflation: Historical Aspects
Over the past 60 years, prices have risen on average about 4 percent per year.
Deflation, meaning decreasing average prices, occurred in Canada in the twentieth century.
Hyperinflation refers to high rates of inflation such as Germany experienced in the 1920s.
In the 1970s prices rose by 7 percent per year.
During the 1990s, prices rose at an average rate of 2 percent per year.
The quantity theory of money is used to explain the long-run determinants of the price level and the
A theory asserting that the quantity of money available determines the price level and that
the growth rate in the quantity of money available determines the inflation rate
Inflation is an economy-wide phenomenon that concerns the value of the economy’s medium of
When the overall price level rises, the value of money falls.
An inverse relationship between the price level and the value of money
The Value of Money
P = the price level (e.g., the CPI or GDP deflator)
P is the price of a basket of goods, measured in money.
1/P is the value of $1, measured in goods.
Example: basket contains one candy bar.
• If P = $2, value of $1 is 1/2 candy bar
• If P = $3, value of $1 is 1/3 candy bar
Inflation drives up prices and drives down the value of money.
The Quantity Theory of Money
A theory asserting that the quantity of money available determines the price level and that the
growth rate in the quantity of money available determines the inflation rate
The supply and demand for money determines the value of money
Developed by 18 century philosopher, David Hume and the classical economists
Advocated more recently by Nobel Prize Laureate Milton Friedman
Asserts that the quantity of money determines the value of money
We study this theory using two approaches:
• A supply-demand diagram
• An equation
Money Supply (MS)
In real world, determined by the Bank of Canada (BoC), the banking system, consumers.
In this model, we assume the BoC precisely controls money supply (MS) and sets it at some fixed
When BOC sells bonds in open market operations, it receives dollars in exchange and contracts
the money supply
When BOC buys government bonds it pars out dollars and expands the money supply
If any of these dollars are deposited in banks that then hold them as reserves, the money
multiplier swings into action, and these open market operations can have an even greater effect
on the money suppl
Money Demand (MD) Refers to how much wealth people want to hold in liquid form.
Depends on P: An increase in P reduces the value of money, so more money is required to buy
goods & services.
Thus, quantity of money demanded is negatively related to the value of money and positively
related to P, other things equal. (These “other things” include real income, interest rates,
availability of ATMs.)
In long run, the overall level of prices adjusts to the level at which the demand for money equals
The horizontal axis shows the quantity of money.
The left vertical axis shows the value of money, and
the right vertical axis shows the price level. The
supply curve for money is vertical because the
quantity of money supplied is fixed by the BOC. The
demand curve for money is downward sloping
because people want to hold a larger quantity of
money when each dollar buys less. At the
equilibrium, point A, the value of money (on the left
axis) and the price level (on the right axis) have
adjusted to bring the quantity of money supplied and
When the BOC increases the supply of money, the
money supply curve shifts from MS1 to MS2. The
value of money (on the left axis) and the price level
(on the right axis) adjust to bring supply and demand
back into balance. The equilibrium moves from point
A to point B. This, when an increase in the money
supply makes dollars more plentiful, the price level
increase, making each dollar less valuable A Brief Look at the Adjustment Process
Result from graph: Increasing MS causes P to rise.
How does this work? Short version:
At the initial P, an increase in MS causes excess supply of money.
People get rid of their excess money by spending it on goods & services or by loaning it to
others, who spend it.
Result: increased demand for goods.
But supply of goods does not increase, so prices must rise.
The immediate effect of a monetary injection is to create an excess supply of money
Before the injection, the economy was in eq’m (point A in graph above)
People had as much money as they wanted since the injection of money supply, the quantity
of money supplied now exceeds the quantity demanded
People try to get rid of money in various ways
They might use this excess money to make loans to others by buying bonds or by depositing
the money into a bank savings account
These loans allow other people to buy goods and services hence increase the demand of
goods and services
Demand for more goods includes higher price implementation on goods and services because
of limited inputs available
The increase in the price level, increase the quantity of money demanded because people are
using more dollars for every transaction
Eventually the economy reaches a new eq’m (point B in graph above) at which the quantity of
money demanded again equals the quantity of money supplied balanced money supply
Real vs. Nominal Variables
Nominal variables are measured in monetary
Examples: nominal GDP, nominal interest rate
(rate of return measured in $) nominal wage
($ per hour worked)
Real variables are measured in physical units.
Examples: real GDP, real interest rate
(measured in output) real wage (measured in
An important relative price is the real wage:
o W = nominal wage = price of labour, e.g.,
o P = price level = price of g&s, e.g., $5/unit of
Real wage is the price of labour relative to the price
o W/P = 15/5 = 3 units/hr
The Classical Dichotomy
Classical dichotomy: the theoretical separation of nominal and real variables
It is useful in analyzing the economy because different forces influence real and nominal variables
• Nominal variables are heavily influenced by developments in the economy’s monetary
system, whereas in the long run, the quantity of money is largely irrelevant for understanding
the determinants of important real v