Quantity Theory of Money
Money and Inflation
Inflation: A sustained rise in the general level of prices - the price level.
Price: the rate at which money is exchanged for a good or service
Money: the stock of assets that can be used for transactions.
Functions of Money:
- Store of value (transfer resources from today to tomorrow)
- Units of account (people quote prices and record debts)
- Medium of exchange (what people use to buy good and services)
Qunatity Theory of Money
Transactions and money are related by
- represents the total number of transactions during a period of time
- is the price of a typical transaction (i.e. price level) the number of pounds exchanged
- number of pounds exchanged during a period of time
- is the quantity of money
- is the velocity of money: the rate at which money circulates in the economy
Recall that transcations and output are connected: the more the economy produces, the more goods are bought and sold.
Replace transactions with output to get:
where is nomial GDP, the amount of goods and services purchased in an economy at current prices.
Quantity Equation and Money Demand Function
One of the main determinants of the demand for real money balances is real income. A simple money demand function is:
is how much money people want to hold for every pound of income
The money demand function offers another way to view the quantity equation. Assume (demand equals supply), then
⇒ If people want to hold a lot of money for each dollar of income ( is large), money changes hands infrequently ( is small)
The quantity equation can be viewed as a definition:
With an additional assumption ( constant), the equation becomes a theory about the effects of money:
- A change is the amount of money must cause a proportionate change in nominal GDP
Think of real GDP as an exogenous variable:
- Determined by the factors of production
Think of as exogenously determined by the CB:
Thus, the price level is:
- The price level is determined by the ratio of the effective quantity of money divided by the real income
- An increase in the money supply causes the price level to rise
Quantity Theory of Money for Inflation
The QTM says that, in the long run, a key determinant of the price level is the level of money supply.
Because the inflation rate is the percentage change in the price level, this theory of the price level is also a theory of the inflation rate.
If velocity is constant () and knowing that ,
- is a constant determined by factors of production and productivity
Thus, inflation is caused by “too much money chasing few goods”. The Quantity Theory of Money states that the CB has ultimate control over the rate of inflation.
Nominal v.s. Real Variables
Classical Dichotomy: real and nomial sides of the economy are separate in the long run.
It is classical in the sense that it is assumed that prices are fully flexible. While many economists argue that this assumption is a good descriptor of behaviour in the long run.
Suppose that:
- You change the currency
- You double all prices and wages
- You do both at the same time
Relative prices of goods are unchanged. Thus, people shouldn’t change behaviour. Real ouput should be the same.
Changes in money supply have no real effects on the economy (only affect prices): neutrality of money
But in the short run, neutrality of money does not hold. Prices do not respond immediately and precisely to changes in the money supple. Thus, changes in the money supply can affect the real side of the economy.
Seigniorage
If the increase in the money supply causes inflation, why would the central bank increase the money supple substantially.
All governments spend money:
- Buy goods and services (roads, policy)
- Make transfer payments (pensions)
Methods the government finance its spending:
- Taxes
- Government Debt
- Selling assets
- Printing money: revenue raised by printing money is called seigniorage
By printing money to raise revenue, the government imposes a tax: the holders of money pay the tax.
Cost of Inflation
- Shoeleather cost: more trips to the bank
- Menu cost: print a new menu for the restaurant
- If prices are changed infrequently, the higher the inflation rate, the higher the change in relative prices
- For a firm, it’s harder to asses if an increase in the demand of their product is coming from a change in tastes or a change in relative prices
- May affect tax system such as tax on capital gains
- Planning: personal financial planning, retirement savings, firm investment decisions. Thus it may indirectly affect growth (if inflation is persistently high)
The Phillips Curve and the Quantity Theory
QTM: inflation is caused by “too much money chasing too few goods”
- An increase in real GDP would reduce inflation
Phillips Curve: a booming economy causes the rate of inflation to increase
- : increase in real GDP would increase inflation
The horizon is the key:
- QTM is a long-run model
- In the QTM, an increase in real GDP reflects an increase in supply
- PC is part of the medium-run model
- In the PC, an increase in real GDP reflects an increase in demand
- for example, rightward shifts in the IS curve: when firms face an increase in demand, either adjust quantities or prices
- QTM-supply driven view holds in the long run. In the short run, an increase in output reflects an increase in demand that puts pressure on inflation
Nominal v.s. Real Interest Rates
Inflation and Interest Rates
Nominal interest rate: the interest rate in terms of units of national currency
Real interest rate: the interest rate in terms of a basket of goods
The ex ante (”before the fact”) measure of the real interest rate:
Once inflation is realised, we can obtain ex post (”after the fact”):
The Fisher Effect
From we get , this is the Fisher Effect: nominal interest rate changes for two reasons — real interest rate and expected inflation
By the way, the real interest rate is determined by a number of underlying forces (medium-run factors, such as labour market conditions affecting the natural rate and long-run factors)
However, the nominal interest rate cannot react to actual inflation as it is not known when the nominal interest rate is set.
From Money Growth to Nominal Interest Rates
The quantity theory and the Fisher equation together tell us how money growth affects the nominal interest rate
- According to the quantity theory, an increase in the rate of money growth of 1% causes a 1% percent increase in the rate of inflation
- According to the Fisher equation, a 1% increase in the rate of (expected) inflation, in turn, causes a 1% increase in the nominal interest rate
- As long as expectations follow closely actual inflation
- If inflation is persistent and moderately high, presumably, expectations will follow closely (for example, )
- That’s why we often see a strong correlation between nominal interest rates and actual inflation as predicted by the original Fisher equation
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