Monetarist Economics Equation of Exchange Quantity Theory of

Monetarist Economics Equation of Exchange & Quantity Theory of Money

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

Monetarist Economics Potential GDP Actual and E D Monetarists believe printing money does NOT change full potential GDP Actual GDP A B C Time It only creates inflation! Monetarists do NOT support active monetary policy to adjust business cycle Copyright © 2003 South-Western/Thomson Publishing. All rights reserved.

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 – Monetarist economists assume velocity is stable • Velocity = Nominal GDP Money Supply (M 1) $19. 0 Trillion = 5. 2 times $3. 6 Trillion (M 1) • Determinants of velocity: – Efficiency of the payments system • If efficiency ↑ => Hold less money => Velocity ↑

Money Supply Growth Expansionary Monetary Policy ↑ Money Supply (M 1) $1 Trillion $3. 6 Trillion

Velocity Falling 10. 0 5. 2 In the “real world” Velocity of M 1 falling BUT we hold Velocity constant for monetarist theory

Equation of Exchange MV = PY (Equation of Exchange) where: V = Velocity P = Price level Y = Real GDP M = Money Supply Equation of Exchange Velocity is held constant PY = Nominal GDP

Monetarist Economists • Monetarist economists believe money is NEUTRAL • An increase in MS only raises price level (inflation) MV = PY Example: • • If M ↑ 20% then what happens to Velocity Price Level (P) Real GDP (Y) Nominal GDP (PY) Held constant (V held constant) ↑ 20% Unchanged ($ neutral) ↑ 20%

Example: Equation of Exchange • MV = PY M = $50 V = ? P = $10 • Calculate Velocity: – Velocity = 20 [ $50 X ___ = $10 X 100 ] – Nominal GDP = $1, 000 – R-GDP = 100 pizzas • If ↑ M doubled to $50 => $100: – price level (of pizza) would rise $10 => $20 – Nominal GDP ↑ $2, 000 – Real GDP unchanged (100 pizzas!) Y = 100 pizzas

Monetarist Conclusion • Monetarists believe MONEY IS NEUTRAL so MS has no effect on Real GDP – money does not increase the “full potential” of an economy to produce goods/services • Monetarists believe if the Fed ↑ MS, it causes a proportionate change in Nominal GDP (P Y) and no change in Real GDP – MV = PY No shift of PPF when MS↑ Hold V constant

Quantiy Theory of $ Handout