Ch. 13: Money and the
Economy
James R. Russell, Ph.D., Professor of Economics & Management, Oral Roberts University
©2005 Thomson Business & Professional Publishing, A Division of Thomson Learning
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Money and the Price Level
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Equation of Exchange: MV  PQ
The money supply (M) multiplied by its
Velocity (V) must be equal to the price
level (P) times Real GDP (Q).
Velocity: the average number of
times a dollar is spent to buy final
goods and services in a year.
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The Equation of Exchange


In a large economy,
it is impossible to
count how many
times each dollar
has changed hands.
Velocity must be
equal to GDP
divided by the
average money
supply.
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Interpreting the Equation of
Exchange

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The money supply multiplied by velocity
must equal the price level times Real
GDP: M x V  P x Q
The money supply multiplied by velocity
must equal GDP: M x V  GDP
Total spending or expenditures
(measured by MV) must equal the total
sales revenues of business firms
(measured by PQ): MV  PQ
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From the Equation of Exchange to
the Simple Quantity Theory of
Money
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
Fisher and Marshall assumed changes
in velocity are so small that for all
practical purposes velocity can be
assumed to be constant.
Fisher and Marshall assumed Real GDP
is fixed in the short run.
From these assumptions, we have the
simple quantity theory of money:
changes in M will bring about
proportional changes in P.
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Exhibit 1: Assumptions and
Predictions of the Simple Quantity
Theory of Money
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The Simple Quantity Theory
in an AD-AS Framework
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MV is equal to total expenditures.
Total expenditures is equal to
C+I+G+(EX-IM)
Since MV=TE, MV=C+I+G+(EX-IM)
A change in the money supply or a change
in velocity will change aggregate demand
and therefore lead to a shift in the AD
curve.
In the simple quantity theory of money,
velocity is assumed to be constant.
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Exhibit 2: The Simple Quantity
Theory in an AD-AS Framework
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Dropping the Assumptions
that V and Q are Constant

Remember: M x V  P x Q, then
P=MxV
Q
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Money supply, velocity, and Real GDP
determine the Price Level.
An increase in M or V or a decrease in Q
will cause prices to rise. This is inflation.
A decrease in M or V or an increase in Q
will cause prices to fall. This is deflation.
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Q&A

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If M times V increases, why does P times Q
have to rise?
What is the difference between the equation
of exchange and the simple quantity theory
of money?
Predict what will happen to the AD curve as
a result of each of the following:
– The money supply rises
– Velocity falls
– The money supply rises by a greater percentage
than velocity falls
– The money supply falls.
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Monetarism: Key Views

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Velocity changes in a
predictable way.
Aggregate Demand
depends on the money
supply and on Velocity.
The SRAS curve is
upward sloping.
The Economy is SelfRegulating (Prices and
Wages are flexible)
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Exhibit 3: Monetarism in an AD-AS
Framework
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The Monetarist View of
the Economy
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The economy is self-regulating
Changes in velocity and the money
supply can change aggregate demand.
Changes in velocity and the money
supply will change the price level and
Real GDP in the short run, but only the
price level in the long run.
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The Monetarist View of
the Economy
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Changes in velocity are not likely to offset changes in
the money supply.
Changes in the money supply will largely determine
changes in aggregate demand, and therefore changes
in Real GDP and the price level.
An increase in the money supply will raise aggregate
demand and increase both Real GDP and the price
level in the short run and increase the price level in the
long run.
A decrease in the money supply will lower aggregate
demand and decrease both Real GDP and price level in
the short run and decrease price level in the long run.
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Q&A

What do monetarists predict will happen
in the short run and in the long run as a
result of each of the following:
–
–
–
–

Velocity rises
Velocity falls
The money supply rises
The money supply falls.
Can a change in velocity offset a change
in the money supply (on aggregate
demand)? Explain your answer.
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Inflation

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Inflation: any
increase in the price
level
One-Shot
Inflation: one
time increase in the
price level. An
increase in the price
level that does not
continue.
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Exhibit 4: One-Shot Inflation:
Demand Side Induced
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Exhibit 5: One-Shot Inflation:
Supply-Side Induced
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Continued Inflation From
One-Shot Inflation
Continued increases
in aggregate
demand cause
continued increases
in inflation, or
continued inflation.
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Exhibit 6: Changing One Shot
Inflation Into Continued Inflation
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What Causes Continued
Increases In Aggregate
Demand?
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The only factor that can change continually
in such a way as to bring about continued
increases in aggregate demand is the
money supply.
Money Supply is the only factor that can
continually increase without causing a
reduction in one of the four components of
total expenditures: consumption,
investment, government purchases, or net
exports.
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Q&A

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The prices of houses, cars, and
television sets have increased. Has
there been inflation?
Is continued inflation likely to be
supply-side induced? Explain.
What type of inflation is Milton
Friedman referring to when he says,
“Inflation is always and everywhere a
monetary phenomenon”?
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Money and Interest Rates
What economic variables are affected by a
change in the money supply?
1.
2.
3.
4.
The supply of
loans.
Real GDP
The price level
The expected
inflation rate.
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Money and Interest Rates
A change in the money supply creates a
change in interest rates due to a change
in:
 Liquidity Effect: the supply of loanable
funds.
 Income Effect: Real GDP.
 Price Level Effect: the price level.
 Expectations Effect: the expected
inflation rate.
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Exhibit 7: The Interest Rate and the
Loanable Funds Market
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Exhibit 8: How the Fed Affects the
Interest Rate
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What Happens to the Interest Rate
as the Money Supply Changes?


Change in Money Supply changes:
– Supply of loanable funds
– Real GDP
– The price level
– Expected Inflation
Net impact on Interest Rate
dependent on:
– Timing
– Magnitudes
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The Nominal and Real
Interest Rates

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Nominal interest rate: the interest
rate actually charged (or paid) in the
market; the market interest rate.
The Real Interest Rate: the
Nominal Interest Rate minus the
Expected Inflation Rate.
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Q&A
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If the expected inflation rate is 4% and the
nominal interest rate is 7%, what is the real
interest rate?
Is it possible for the nominal interest rate to
immediately rise following an increase in the
money supply? Explain your answer.
“The Fed only affects the interest rate via
the liquidity effect.” Do you agree or
disagree? Explain your answer.
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Coming Up (Ch. 14):
Monetary Policy
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