THE EQUATION OF EXCHANGE

 MV ≡ PQ
 The equation of exchange is an identity stating that the money supply
(M) multiplied by velocity (V) must be equal to the price level (P)
times Real GDP (Q).
*Velocity is the average number of times a dollar is spent to buy final
goods and services in a year.
FROM THE EQUATION OF EXCHANGE TO THE SIMPLE
QUANTITY THEORY OF MONEY
 The simple quantity theory of money predicts that changes in the
money supply will bring about strictly proportional changes in the
price level.
The AD Curve in the Simple Quantity Theory of Money
 If MV equals C + I + G + (EX – IM), then a change in the money supply (M) or a change in velocity (V) will
change aggregate demand and therefore lead to a shift in the AD curve.
 In other words, aggregate demand depends on both the money supply and velocity. Specifically:
M ↑ AD ↑ AD Curve shift to the right
M ↓ AD ↓ AD Curve shift to the left
V ↑ AD ↑ AD Curve shift to the right
V ↓ AD ↓ AD Curve shift to the left
The AS Curve in the Simple Quantity Theory of Money
 The level of Real GDP is assumed to be constant in the short run. The AS curve is
vertical at this level of GDP.
AD and AS in the Simple Quantity Theory of Money
 In simple quantity theory of money, an increase in the money supply will shift AD
curve rightward and increase the price level. A decrease in the money supply will
shift the AD curve leftward and decrease the price level.
The Four Monetarist Positions
 Velocity Changes in a Predictable Way
 Aggregate Demand Depends on the Money Supply and on Velocity
 The SRAS Curve is Upward-Sloping
 The Economy is Self-Regulating (Prices and Wages are Flexible)
THE MONETARIST VIEW OF THE ECONOMY
 The economy is self-regulating.
 Changes in velocity and the money supply can change aggregate demand.
 Changes in velocity and the money supply will change the price level and the Real
GDP in the short term, but only the price level in the long run.
ONE-SHOT INFLATION
 ONE-SHOT INFLATION DEMAND-SIDE INDUCED
 ONE-SHOT INFLATION SUPPLY-SIDE INDUCED

CONTINUED INFLATION
 FROM ONE SHOT INFLATION TO CONTINUED INFLATION
The Money Supply, the Loanable Funds Market, and Interest
Rates
 The Supply of Loans
 Real GDP
 The Price Level
 The Expected Inflation Rate
 THE DIFFERENCE BETWEEN PRICE LEVEL EFFECT AND THE
EXPECTATIONS EFFECT
To many people, the price-level effect sounds the same as the expectations
effect. After all, both have something to do with price level. But they are different.
The price level effect refers to the change in the interest rate that is related to the
actual rise in price level. As the price level is rising, people’s expected inflation rate
is rising. They may feel they know where the price level is headed and adjust
accordingly. Any change in the interest rate due to a rise in the expected inflation
rate is now over, and therefore the expected inflation rate no longer has an effect on
the interest rate. But certainly the price level is still has an effect because the price
level is higher than it was originally. In the end, the effect on the interest rate due to a
rise in price level remains, and the effect of the interest rate due to a rise in the
expected inflation rate disappears.
 THE NOMINAL AND REAL INTEREST RATES

Real Interest Rate = Nominal Interest Rate – Expected Inflation Rate

Nominal Interest Rate = Real Interest Rate – Expected Inflation Rate