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MONEY, OUTPUT AND PRICES

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

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  1. MONEY, OUTPUT AND PRICES Prof. Yoram Landskroner

  2. 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

  3. 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

  4. 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)

  5. 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: • 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

  6. Early/Classical QTM • 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

  7. 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)

  8. 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

  9. Modern QTM 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*)

  10. 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)?

  11. 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

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