Quantity equation (equation of exchange)
MV= PY (quantity equation)
M/P= real money balances, the purchasing power of the money supply
Money supply is controlled by the Fed, we want to take it and adjust for prices
(M/P) =kY (money demand)
K=1/V (connection b/w money demand and quantity equation)
Where k= how much money people wish to hold for each dollar of income (its exogenous)
(M/P) is the demand for real balances
M ×V =P ×Y
When people hold lots of money relative
to their incomes (k is large),
money changes hands infrequently (V is small).
Assume V is constant and exogenous… Leading to the Quantity Theory of Money
How the price level is determined:
With V constant, the money supply determines nominal GDP (P Y ).
ΔM ΔV ΔP ΔY
+ = +
M V P Y
Real GDP (Y) is determined by the economy’s
supplies of K and L and the production function (Chap 3).
ΔM ΔY ΔP
π = − π =
M Y P
The price level is
P = (nominal GDP)/(real GDP).
(Greek letter “pi”)
denotes the inflation rate:
The growth rate of a product equals the sum of the growth rates Normal economic growth requires a certain amount of money supply growth to facilitate the
growth in transactions, however money growth in excess of this amount leads to inflation
Y/Y depends on growth in the factors of production and on technological progress (all of which
we take as given, for now). Hence, the Quantity Theory predicts a one-for-one relation
between changes in the money growth rate and changes in the inflation rate.
The quantity theory of money implies:
1. Countries with higher money growth rates should have higher inflation rates.
2. The long-run trend behavior of a country’s inflation should be similar to the long-run trend in
the country’s money growth rate.
To spend more without raising taxes or selling bonds, the govt can print money.
The “revenue” raised from printing money
is called seigniorage
The inflation tax: Printing money to raise revenue causes inflation. Inflation is like a
tax on people who hold money
Real interest rate, r
adjusted for inflation: r = i
Chap 3: S = I determines r .(S, I and r are real variables)
Hence, an increase in causes an equal increase in i.
This one-for-one relationship is called the Fisher effect.
Suppose V is constant, M is g