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This paper explains our agreements and differences and reaches the following conclusions. First, several arguments provided do not invalidate the theory of third best, at least if correctly interpreted and applied. We may have useful piecemeal welfare policies after all, if appropriately used.
- Yew Kwang Ng
- 2017
- Overview
- Lesson summary
- The equation of exchange
- The quantity theory of money
- A slightly different version of the quantity theory of money
- The impact of changes in the money supply will depend on whether the economy is at full employment or not
- The growth of the money supply determines the growth of the price level in the long run
- Key misperceptions
- Questions for review
In this lesson summary review and remind yourself of the key terms and calculations related to money growth and inflation. Topics include the quantity theory of money, the velocity of money, and how increases in the money supply may lead to inflation.
Lesson summary
The nobel prize winning economist Milton Friedman once said that “Inflation is always and everywhere a monetary phenomenon.” The evidence to back his claim was pretty clear: whenever countries experience very high inflation for a sustained period of time, those countries also experience a rapid increase in the rate of growth of their money supply.
At the same time, increases in the money supply in those countries isn’t associated with sustained increases in output that we would have predicted with monetary policy. It seems that in the short run, increases in the money supply lead to increases in output, but in the long run increases in the money supply just cause inflation.
Key terms
Key equations
The nobel prize winning economist Milton Friedman once said that “Inflation is always and everywhere a monetary phenomenon.” The evidence to back his claim was pretty clear: whenever countries experience very high inflation for a sustained period of time, those countries also experience a rapid increase in the rate of growth of their money supply.
At the same time, increases in the money supply in those countries isn’t associated with sustained increases in output that we would have predicted with monetary policy. It seems that in the short run, increases in the money supply lead to increases in output, but in the long run increases in the money supply just cause inflation.
The equation of exchange states that the effective money supply is equal to nominal GDP:
M×V=P×Y
Where
M×V=the effective money supply is the money supply(M)multiplied by the velocity of money(V)P×Y=is the price level (P) multiplied by real GDP(Y)
Note that P×Y is the same as nominal GDP.
The equation of exchange of money is actually just saying that all of the nominal GDP that is bought (P×Y ) has to be bought with the effective amount of money available (M×V ). Think of the quantity theory of money this way: “you need $100 to buy $100 worth of stuff.”
M×V=P×Y
Where V, the velocity of money, is constant.
The quantity theory of money has these important implications:
•If output (Y ) is increasing and velocity is constant, the money supply will have to increase to keep the price level from decreasing; and
•An increase in the money supply (M ) without an increase in output (Y ) causes the price level to change by the same change in the money supply. In other words, output doesn’t change, but when the money supply doubles, the price level also doubles.
For example, suppose we had a really simple economy that only produced mangoes. The velocity of money is 5 and there are 100 mangoes:
%ΔM+%ΔV=%ΔP+%ΔY
This form of the equation is just the first form after some complicated math (that is beyond the scope of the course) has been applied. These mathematical operations transformed each variable into their growth rates.
For example, suppose real GDP is growing at 5% , the velocity of money is constant, and the money supply is growing at 5% . Then this equation becomes:
%ΔM+%ΔV=%ΔP+%ΔY5%+0%=%ΔP+5%
We conclude from this that the rate of change of the price level is 0% .
But, if the money supply is growing by 7% , the this equation becomes:
Previously, we learned that a central bank can influence output by increasing the money supply. At first glance, it might seem like the quantity theory of money contradicts this, because when the money supply increases only the price level change.
The important assumption that drives this result is that output (Y ) is fixed. This might be true in the long-run, but not in the short-run. In the short-run, an increase in the money supply decreases the nominal interest rate, which increases investment and real output. However, according to the self-correcting mechanism, the accompanying inflation will eventually lead to a decrease in short-run aggregate supply (SRAS ). The decrease in SRAS returns the economy to full employment and a new, permanently higher price level.
The quantity theory of money treats money as neutral. That doesn’t mean that changes in the money supply have no impact. Rather, “neutral” means that changes in the money supply have no impact on one variable in particular: real output. In the long run, real output will depend on resources and technology, not the money supply.
This means that changes in the price level (and therefore the rate of inflation) depend primarily on changes in the money supply.
Some people assume that money neutrality means monetary policy is pointless. In fact, Milton Friedman, the father of monetarism, believed that the lack of monetary policy contributed to the severity of the Great Depression. Rather, money neutrality states that monetary policy has limits to its appropriate uses. The money supply should grow enough t...
1.What assumption turns the equation of exchange into the quantity theory of money?
2.If the velocity of money is constant and output is constant, what happens to the price level if the money supply doubles?
3.If the money supply is $100 and nominal GDP is $500 , what is the velocity of money?
[I've tried my best. Can I check my work?]
On the other hand, the income-expenditure approach is the modern theory of money. Let us discuss these theories of money in detail. a. Quantity Velocity Approach: Till now, the economists believed that the price level show changes because of the changes in quantity (demand and supply) of money.
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10) and goes on to discuss the commodity theory, the state theory, and the credit theory of money. In the one page dedicated to Carl Menger’s theory, the author argues that it is a “commodity” theory of money. That, of course, is a misunderstanding; Menger’s theory is a “catallactic” theory.
Which of the following scenarios provides the best evidence that inflation has occurred? a. an increase in the overall price level b. A person whose salary has increased can purchase fewer goods and services.
Nov 2, 2018 · 1. Metaphysics. 1.1 What is Money? 1.2 What is Finance? 2. Epistemology. 3. Philosophy of Science. 4. Ethics. 4.1 Money as the Root of All Evil? 4.1.1 The love of money. 4.1.2 Usury and interest. 4.1.3 Speculation and gambling. 4.2 Fairness in Financial Markets.
The classical quantity theory of money is based on two fundamental assumptions: First is the operation of Say’s Law of Market. Say’s law states that, “Supply creates its own demand.”. This means that the sum of values of all goods produced is equivalent to the sum of values of all goods bought.
