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MONEY, OUTPUT AND PRICESPowerPoint Presentation

MONEY, OUTPUT AND PRICES

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MONEY, OUTPUT AND PRICES

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Prof. Yoram Landskroner

- 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 starting point (Fisher 1911) the relationship between money supply (quantity of money) M
and value of spending on goods and services during a year:

- P*Y
Where

P = General price level

Y = Real output of goods and services (quantity)

PY is therefore nominal output (nominal GDP)

- P*Y

- The link between the two is the Velocity ofMoney, V:
- V is the velocity of money,the rate of turnover of money
We can now establish the exchange equation:

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

- 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:
Assumes:

- 1. V is constant in the short run
- 2. V is independent of M
- 3. Y is at full employment

Results and implications:

- 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)

- Because the model relates money and aggregate output it can also be taken to be a theory for the demand for money:
M= k*PY

Where k=1/V is a constant

This is also known as the Cambridge equation

- The demand for money is determined by the transactions generated by nominal output

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:

- 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
THE END