Quantity Theory of Money

Keynesian Economics
In one sense, Keynesian economics is the
foundation of all of macroeconomics.
Now used more narrowly, Keynesian sometimes
refers to economists who advocate active
government intervention in the macroeconomy.
We begin with an old debatethat between
Keynesians and monetarists.

Monetarism
The debate between monetarist and Keynesian
economics is complicated because it means
different things to different people.
If we consider the main monetarist message to be
that money matters, then almost all economists
would agree.
Monetarism, however, is usually considered to go
beyond the notion that money matters.

Monetarism
The Velocity of Money
velocity of money The number of times a
dollar bill (money) changes hands, on
average, during a year; the ratio of nominal
GDP to the stock of money.
The income velocity of money (V) is the
ratio of nominal GDP to the stock of money
(M):

GDP
V
M

Velocity of Money
Velocity is the number of times that
money must change hands in economic
transactions during a given year for an
economy to reach its GDP level.

$ 5 trillio n p e r y e a r
v e lo c ity o f m o n e y
5 tim e s p e r y e a r
$ 1 trillio n

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Monetarism
The Velocity of Money
We can expand this definition slightly by noting that
nominal income (GDP) is equal to real output (income) (Y)
times the overall price level (P):

GDP P Y

Through substitution:

P Y
V
M
or

M V P Y
quantity theory of money The theory based on the identity
M V P Y and the assumption that the velocity of money
(V) is constant (or virtually constant).

Monetarism
The Quantity Theory of Money
The key assumption of the quantity theory
of money is that the velocity of money is
constant (or virtually constant) over time. If
we let V denote the constant value of V,
the equation for the quantity theory can be
written as follows:

M V P Y

Inflation and the Velocity of Money

The equation of exchange, or quantity
equation, links the money supply and
velocity to nominal GDP:

m o n e y su p p ly x v e lo c ity n o m in a l G D P
M x V P x y
If velocity is predictable, we can use the
quantity equation and the supply of
money to predict nominal GDP.

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Inflation and the Velocity of Money

The basic quantity equation can be used to derive
a closely related formula for understanding
inflation in the long run, called the growth
version of the quantity equation:

For
example:
Growth
rate
of the money
supply

10%

7%
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Growth
rate of
velocity

0%

Growth
rate of
prices

+ of real output

Growth
rate of
prices

Growth rate of prices

Growth rate

3%

inflation

From the Equation of Exchange to the

Simple Quantity Theory of Money
The simple quantity theory of money
assumes that both V and Q are constant.
From these assumptions, we have the simple
quantity theory of money:

changes in M will bring

about proportional changes in
P.

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Assumptions and Predictions of the

Simple Quantity Theory of Money

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The Simple Quantity Theory in an ADAS Framework

MV is equal to total expenditures.
Total expenditures is AE = C+I+G+(EXIM)
Since MV=AE, MV=C+I+G+(EX-IM)
In the simple quantity theory of money,
velocity is assumed to be constant, so a
change in money supply will change
aggregate demand and therefore lead
to a shift in the AD curve.
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The Simple Quantity Theory in an ADAS Framework (Continued)

In the simple quantity theory of money, real GDP
is fixed in short run. Thus, the AS curve is vertical.
Also, in the simple quantity theory of money, an
increase in money supply will shift the AD curve
rightward and increases the price level, and
A decrease in the money supply will shift the AD
curve leftward and decreases the price level.

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The Simple Quantity Theory in an ADAS Framework (Continued)

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Dropping the Assumptions that V and

Q are Constant
Remember: M x V P x Q, then

P=MxV

Q
Money supply, velocity, and Real GDP
determine the Price Level.
An increase in M or V or a decrease in Q will
cause prices to rise. This is inflation.
A decrease in M or V or an increase in Q will
cause prices to fall. This is deflation.

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Monetarism

Inflation as a Purely Monetary

Phenomenon
In the strict monetarist view, changes in M affect
only P and not Y, so inflation (an increase in P) is
always a purely monetary phenomenon.
The price level will not change if the money supply
does not change.
There is considerable disagreement as to whether
the strict monetarist view is a good approximation
of reality.
Almost all economists agree, however, that
sustained inflationinflation that continues over
many periodsis a purely monetary phenomenon.
Inflation cannot continue indefinitely without

Monetarism

The Keynesian/Monetarist Debate

Monetarists were skeptical of the Feds ability to
manage the economyto expand the money supply
during bad times and contract it during good times.
The leading spokesman for monetarism, Milton
Friedman, advocated a policy of steady and slow money
growthspecifically, that the money supply should
grow at a rate equal to the average growth of real
output (income) (Y).
While not all Keynesians advocated an activist federal
government, many advocated the application of
coordinated monetary and fiscal policy tools to reduce
instability in the economyto fight inflation and
unemployment.