Money output and prices
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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

Money output and prices

  • 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

Money output and prices

Money output and prices

  • 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

Money output and prices

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)

Money output and prices

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*)

Money output and prices

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)?

Money output and prices

  • 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