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MONEY, OUTPUT AND PRICES. Prof. Yoram Landskroner. QUANTITY THEORY OF MONEY. Hypothesizes relation between money, the general price level and aggregate output in the economy

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Money output and prices

Prof. Yoram Landskroner

Quantity theory of money

  • Hypothesizes relation between money, the general price level and aggregate output in the economy

  • Where the most common measure of aggregate output is the Gross Domestic Output (GDP):the value of all final goods and services produced in the economy during a year

  • Measures of general price level:

    • GDP price deflator = nominal GDP divided by real GDP

    • Consumer Price index (CPI): weighted average price of a “basket” of goods and services bought by a typical urban household

  • Real versus Nominal terms:

    • Nominal: values measured in current prices ,nominal GDP

    • Real: constant or beginning of year prices, real GDP, measure of quantities of goods and services

    • The difference between the two is the change in the price level

  • The link between the two is the money supply (quantity of money) M Velocity ofMoney, V:

    • V is the velocity of money,the rate of turnover of money

      We can now establish the exchange equation:

  • M*V = P*Y

    This is tautology:

    Value of money expensed on goods and services during a year equals the value of goods and services when purchased

Early classical qtm
Early/Classical QTM money supply (quantity of money) M

  • To convert identity to theory of the determination of nominal output, have to explain the determination of

    • velocity (institutional arrangements in the economy) and

    • money supply (central and commercial banks)

  • Early/Classical QTM:


    • 1. V is constant in the short run

    • 2. V is independent of M

    • 3. Y is at full employment

Results and implications: money supply (quantity of money) M

  • Changes in nominal output are determined solely by changes in the money supply

  • There is a proportional relationship between money and prices:

    M = (Y/V) P

    Where (Y/V) is a constant.

  • Thus an increase in money (quantity) supply is the only cause for an increase in the price level (inflation)

Modern qtm
Modern QTM also be taken to be a theory for the demand for money:

Following data collected after WWII assumptions of the old QTM were relaxed:

  • 1. V may vary even in the short run (it declined sharply during the Great Depression)

  • 2. Changes in M induce changes in V in the opposite direction

  • 3. Assumption of full employment may be unrealistic (Y < Y*)

Implications and issues: also be taken to be a theory for the demand for money:

  • An increase in M may cause an increase in Y and/or P or a decline in V

  • Issue of speed of adjustments of aggregates to changes in M (P vs. Y)

  • Increase in M increases expenditure (MV) or nominal product (PY)?

  • Is velocity constant or can the QTM be used to predict inflation?

  • M2 velocity remained stable in the 1980’s

  • This lead the Federal Reserve to use the QTM to predict inflation

  • In the early 1990’s M2 growth declined but it settled down again in the late 1990’s