M&B Ch (19) Inflation PDF

The relationship between money supply and inflation  Quantity Theory of Money Velocity of Money and The Equation of Exchange: 19-2 © 2016 Pearson Education, Inc. All rights reserved.  Quantity Theory of Money Velocity fairly constant in short run Aggregate output at full...

The relationship between money supply and inflation  Quantity Theory of Money Velocity of Money and The Equation of Exchange: 19-2 © 2016 Pearson Education, Inc. All rights reserved.  Quantity Theory of Money Velocity fairly constant in short run Aggregate output at full-employment level Changes in money supply affect only the price level Movement in the price level results solely from change in the quantity of money 19-3 © 2016 Pearson Education, Inc. All rights reserved.  Quantity Theory of Money Demand for money: To interpret Fisher’s quantity theory in terms of the demand for money… Divide both sides by V 1 1 k= M = × PY V V When the money market is in equilibrium M = Md Let M d = k × PY Because k is constant, the level of transactions generated by a fixed level of PY determines the quantity of Md. The demand for money is not affected by interest rates. 19-4 © 2016 Pearson Education, Inc. All rights reserved.  Quantity Theory of Money From the equation of exchange to the quantity theory of money: – Fisher’s view that velocity is fairly constant in the short run, so that , transforms the equation of exchange into the quantity theory of money, which states that nominal income (spending) is determined solely by movements in the quantity of money M. P × Y = M ×V 19-5 © 2016 Pearson Education, Inc. All rights reserved.  Quantity Theory and Inflation Percentage Change in (x ✕ y) = (Percentage Change in x) + (Percentage change in y) Using this mathematical fact, we can rewrite the equation of exchange as follows: %∆M + %∆V = %∆P + %∆Y Subtracting from both sides of the preceding equation, and recognizing that the inflation rate, is the growth rate of the price level, π = %∆P = %∆M + %∆V − %∆Y Since we assume velocity is constant, its growth rate is zero, so the quantity theory of money is also a theory of inflation: π = %∆M − %∆Y 19-6 © 2016 Pearson Education, Inc. All rights reserved.