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Lecture 17

ECON 3430 Lecture 17: CH20 book powerpoint notes

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ECON 3430
Brenda Spotton- Visano

Quantity Theory, Inflation, and the Demand for Money Chapter 20 • Velocity of Money and The Equation of Exchange The equation of exchange: MV = PY • M = the money supply • P = price level • Y= aggregate output (real GDP) • PY = aggregate nominal income (nominal GDP) • V = velocity of money (average number of times per year that a dollar is spent • The Quantity Theory of Money and Determinants of Velocity • Irving Fischer: velocity is determined by institutions – Charge accounts and credit cards for transactions – Velocity fairly constant in short run • Aggregate output at full-employment level • Changes in money supply affect only the price level • Movement in the price level results solely from change in the quantity of money • Demand for Money • Alternative to Fischer’s quantity theory is in terms of demand for money (the quantity people want to hold) • Take equation of exchange, divide by V M = PY / V d • If money supply equals money demand, then M = M • If velocity of money is constant, then let k = 1/V M = kPY • Demand purely a function of income PY • From the Equation of Exchange to the Quantity Theory of Money • From the equation of exchange to the quantity theory of money – Fisher’s view that velocity is fairly constant in the short run transforms the equation of exchange into the quantity theory of money, which states that nominal income (spending) is determined solely by movements in the quantity of money M • Quantity Theory and the Price Level • Because the classical economists (including Fisher) thought that wages and prices were completely flexible, they believed that the level of aggregate output Y produced in the economy during normal times would remain at the full-employment level – dividing both sides by , we can then write the price level as follows: • Quantity Theory and Inflation • The quantity theory of money can become a theory of inflation • Price level is proportional to the money supply times the velocity of money divided by real GDP • Since we assume velocity is constant, • The quantity theory of inflation indicates that the inflation rate equals the growth rate of the money supply minus the growth rate of aggregate output • Testing the Quantity Theory of Money • The quantity theory of money is a good theory of inflation in the long run, but not in the short run • The Long Run – Provides a long-run theory because it is based on the assumption that wages and prices are flexible – Empirically, the growth rate of aggregate output over 10-year periods does not vary that much – Good explanation for cross-country inflation differences • The Short Run – Many years where money growth is high but inflation is low • Relationship Between Inflation and Money Growth • Annual Canadian Inflation and Money Growth Rates • Budget Deficits and Inflation • There are two ways the government can pay for spending: raise revenue or borrow – Raise revenue by levying taxes – Go into debt by issuing government bonds • The government can also create money and use it to pay for the goods and services it buys • The government budget constraint Deficit = Spending – Taxes = Change in monetary base + change in government bonds • Budget Deficits and Inflation (cont’d) • The government budget constraint thus reveals two important facts: – If the government deficit is financed by an increase in bond holdings by the public, there is no effect on the monetary base and hence on the money supply – But, if
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