Quantity Theory of Money

Why Money is Neutral!

Quantity Theory of Money

• What: Monetarist Theory which states the quantity of money determines the value of money (price level) – i.e. the primary cause of inflation is the growth of money supply

• Implication: In long run, ↑ MS has no effect on real GDP– ↑ MS only raises price level

“Inflation is always and everywhere a monetary phenomenon”

Milton Friedman

Leading Monetarist Economist

Velocity of Money

• The velocity of money is the number of times the average dollar bill is spent in a year– it has been relatively stable since 1960– Monetarists assume velocity is stable

• Determinants of velocity:– Efficiency of the payments system

• Efficiency ↑ => Hold less money => Velocity ↑

Indexes(1960 = 100)

2,000

1,000

500

0

1,500

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

Velocity

M2

Nominal GDP

Stability of the Velocity of Money

Equation of Exchange

V = (P Y)/M

where: V = Velocity

P = Price level Y = Real GDP M = Money Supply

Re-write Equation

MV = PY

Known as:

“Equation of Exchange”

Example: Equation of Exchange

• MV = PY• Economy: M = $50 Y = 100 pizzas P = $10 V = ?

– Calculate Velocity:

• Velocity = 20 [ 50 * ___ = 100 * $10 ]

• An ↑ quantity of money must be reflected in one of 3 variables:– price level must rise (inflation)– real GDP must rise (more goods sold)– or

– velocity of money must fall

But velocity is constant

MV = PY• An ↑ quantity of money must be reflected in one of 3

variables:– The price level must rise (inflation)– the real GDP must rise (more goods sold)– or

– Or the velocity of money must fall

So, Price Level must rise!

↑ Money Supply does not raise full potential.

Money is Neutral!• If the Fed increases the quantity of money, it causes a proportionate

change only in Nominal GDP (P Y)

• Because MONEY IS NEUTRAL, money has no effect on Real GDP– Why: money does not increase the “full potential” of an

economy to produce goods/services

MV = PY

Qty

Food

Qty

Shelter

. B

. A

. C

(100, 0)

(0,100)

(50,50)

(100, 0)

(0,100)

(50,50)

No shift of PPF when MS↑

Quantiy Theory of $ Handout