Chapter 22
Quantity Theory, Inflation,
and the Demand for
Money
Money Growth, Money Demand, and
Monetary Policy
• How is inflation linked to money growth?
• The Quantity Theory of Money and the
Velocity of Money
Inflation and Money Growth
Inflation and Money Growth
• Previous slide shows cannot have high,
sustained inflation without monetary
accommodation
• To avoid sustained high inflation, central bank
must watch money growth
• Something beyond just differences in
money growth accounts for the differences
in inflation across countries.
The Equation of Exchange: M x V = P x Y
Nominal GDP = Price level(P) x Real Output(Y)
Quantity of Money(M) x Velocity(V) = Nominal GDP
MxV =PxY
Velocity of Money (V):
PxY
Velocity(V ) 
M
These relationships are definitions
http://research.stlouisfed.org/fred2/categories/24
The Equation of Exchange – Dynamic Form
From M x V  P x Y
we can derive
%M  %V  %P  %Y
Money Growth + Velocity Growth = Inflation + Output Growth
  %P  %M  %V  %Y
From the Equation of Exchange to the
Quantity Theory of Money
The Quantity Theory of Money (Irving Fisher)
• assume velocity is constant => %ΔV = 0
• or at least stable
• economy at full employment.
• Strong condition %ΔY = 0.
• Double M => Double P
• Inflation is a purely a monetary phenomenon
(Milton Friedman).
Budget Deficits and Inflation
• There are two ways the government
can pay for spending: raise revenue or
borrow
-Raise
revenue by levying taxes or go
into debt by issuing government bonds
• The government can also create
money and use it to pay for the goods
and services it buys
Budget Deficits and Inflation
• The government budget constraint:
Def = G – T = ∆B + ∆MB
• reveals two important facts:
– If the government deficit is financed by an increase in
bond holdings by the public (∆B) , there is no effect
on the monetary base and hence on the money
supply
– But, if the deficit is not financed by increased bond
holdings by the public, the monetary base and the
money supply increase (∆MB)
Budget Deficits and Inflation
• the monetary base and the money
supply increase (∆MB)
• Two cases –
- The Treasury issues currency
- Not allowed in US and many countries
- Central bank OMO
- Monetizing the debt
• Financing a persistent deficit by
money creation will lead to sustained
inflation
Is Velocity Stable?
The Scale obscures the short-run movements in M2
Velocity of Money
Substantial short-run fluctuations in M2 velocity.
But the long-run trend is a modest increase from 1.72 to 1.82
over 45 years.
Velocity of Money
• The data tend to confirm Fisher’s conclusion
that in the long run (40 to 50 years) the
velocity of money (M2) is stable
• However, central banker’s are concerned
with inflation over quarters and the next few
years.
• Velocity is volatile in the short-run as shown
on the next chart.
Change in the Velocity of M1 and M2
from Year to Year, 1915–2008
To understand the velocity of money, must understand the
demand for money.
Keynesian Demand for Money
• Two motives for holding money:
• Transactions demand
• Speculative or Portfolio demand
Transactions Demand for Money
• The quantity of money the public holds
for transactions purposes depends
• on nominal income – P x Y
• the cost of holding money
• and the availability of substitutes
• As P and/or Y increase => money demand
will increases
• As opportunity cost increases (i) => money
demand will decrease
Transactions Demand for Money
• Higher i => higher opportunity cost of
holding money => the less money
individuals and businesses will hold for
a given level of transactions => higher
velocity of money.
• High inflation countries, the opportunity
cost of holding money is high.
• M and V are increasing, so the increase in P is
greater than the increase in M.
Inflation and Money Growth
Further Developments in the Keynesian
Approach
• Baumol - Tobin model of Transactions
demand
• The transaction component of the demand
for money is negatively related to the level
of interest rates – opportunity cost and
availability of alternatives
Demand for Cash Balances in the BaumolTobin Model
Income and spending are not
synchronized
Mismatch between the timing of money
inflow to a household and the timing of
money outflow for household expenses.
Cash Balances in the Baumol-Tobin Model
Income arrives only once a month, but spending takes place
at a constant rate.
Cash Balances in the Baumol-Tobin Model
Could decide to deposit entire paycheck ($1,200) into
checking account at the start of the month and run balance
down to zero by the end of the month. In this case, average
balance would be $600.
Cash Balances in the Baumol-Tobin Model
Alternatively, could also choose to put half paycheck into checking account and buy a
bond with the other half of income. At midmonth, would sell the bond and deposit the
$600 into checking account to pay the second half of the month’s bills. Following this
strategy, average money holdings would be $300.
Keynesian Portfolio or Speculative Demand
for Money
• As a store of value, money provides
diversification when held with a wide variety of
other assets, including stocks and bonds
• Portfolio demand depends on
• Wealth
• the expected return relative to the alternatives
• expectations that interest rates will change in the
future
• Risk
• Liquidity
Velocity is not constant!
• The procyclical movement of interest
rates should induce procyclical
movements in velocity.
• Interest rates   opportunity cost 
Demand for money   velocity 
20-27
Targeting Money Growth
Two criteria for the use of money growth as
a monetary policy target:
• A stable link between the monetary base and
the quantity of money: MB x m = M
• A predictable relationship between the
quantity of money and inflation: M x V = P x Y
(MB x m) x V =P x Y
• Possible explanation for the instability of U.S.
money demand over the last quarter of the 20th
century.
• Primary - The introduction of financial instruments
that paid higher returns than money.
• Most Central Banks use interest rates as
their operating instrument
• Interest rates are the link between the
financial system and the real economy
• While inflation is tied to money growth in
the long run, interest rates are the tool
policymakers use to stabilize inflation in
the short run.