MONEY, OUTPUT AND PRICES
Prof. Yoram Landskroner
Prof. Landskroner
QTM
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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

Prof. Landskroner
QTM
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 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
Prof. Landskroner
QTM
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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)
Prof. Landskroner
QTM
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
The link between the two is the Velocity of
Money, V:
P *Y
V
M
 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
Prof. Landskroner
QTM
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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

Prof. Landskroner
QTM
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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)
Prof. Landskroner
QTM
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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

Prof. Landskroner
QTM
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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*)
Prof. Landskroner
QTM
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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)?
Prof. Landskroner
QTM
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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
Prof. Landskroner
QTM
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