Ch. 14: Money and the Economy
Del Mar College
John Daly
©2003 South-Western Publishing, A Division of Thomson Learning
Money and the Price Level
• The Equation of Exchange is MV = PQ
• The money supply (M) multiplied by the
Velocity (V) must be equal to the price level
(P) times Real GDP (Q).
• Velocity is the average number of times a
dollar is spent to buy final goods and
services in a year.
The Equation of Exchange
• In a large economy
such as ours, it is
impossible to figure
out how many times
each dollar has
changed hands.
• Velocity must be equal
to GDP divided by the
average money supply.
Interpreting the Equation of Exchange
• The money supply multiplied by velocity
must equal the price level times Real GDP
MxVPxQ
• 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
From the Equation of Exchange to the
Simple Quantity Theory of Money
• 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.
The Simple Quantity Theory in
an AD-AS Framework
• 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.
• But, in the simple quantity theory of money,
velocity is assumed to be constant.
The Simple Quantity Theory in
an AD-AS Framework
Dropping the Assumptions that V
and Q are Constant
• Remember: M x V  P x Q, then
P=MxV
Q
• 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.
Q&A
• 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.
Monetarism: Key Views
• 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)
Monetarism in an AD-AS Framework
The Monetarist View of the
Economy
• 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.
The Monetarist View of the
Economy
• 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.
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.
Inflation
• Inflation refers to any
increase in the price
level
• One shot inflation is a
one time increase in
price level.
• There are several
theories on one-shot
inflation:
One-Shot Inflation: Demand Side Induced
One-Shot Inflation: Supply-Side Induced
Continued Inflation From OneShot Inflation
Continued increases in
aggregate demand
cause continued
increases in inflation,
or continued inflation.
Changing One Shot Inflation Into Continued Inflation
What Causes Continued
Increases In Aggregate Demand?
• 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.
Q&A
• The prices of houses, cars, and television sets
have increased. Has there been inflation?
• Is continued inflation likely to be supplysided? Explain your answer.
• What type of inflation is Milton Friedman
referring to when he says, “Inflation is always
and everywhere a monetary phenomenon”?
Money and Interest Rates
What economic variables are
affected by a change in the
money supply:
1. Money & the supply of
loans
2. Money & the Real GDP
3. Money & the Price Level
4. They can also affect the
expected inflation rate.
Money and Interest Rates
• Anything that affects either the supply of loanable
funds or the demand for loanable funds will
obviously affect the interest rate.
• A change in the interest rate due to a change in the
supply of loanable funds is called the liquidity
effect.
• When Real GDP increases, both the supply of and
demand for loanable funds increase. The demand
for loanable funds increases more than the supply
of loanable funds, so that the interest rate rises.
This change in interest rate is called the Income
effect.
Money and Interest Rates, cont.
• When the price level rises, the purchasing power
of money falls, and people may increase their
demand for credit or loanable funds in order to
borrow the funds necessary to buy a fixed bundle
of goods. This change in the interest rate due to a
change in the price level is called the price-level
effect.
• An expected inflation rate increases the demand
for loanable funds and decreases the supply of
loanable funds, so that the interest rate is higher.
This change in the interest rate is called the
expectations effect.
The Interest
Rate and the
Loanable
Funds
Market
What Happens to the Interest Rate
as the Money Supply Changes?
A change in the money
supply affects the
economy in many ways:
changing the supply of
loanable funds directly,
changing Real GDP and
therefore changing the
demand for and supply of
loanable funds, changing
the expected inflation rate,
and so on.
The Nominal and Real Interest Rates
• Nominal interest rate is the interest rate that
comes about through the interaction of the
demand for and supply of loanable funds.
• The nominal interest rate may not be the
true cost of borrowing because part of the
nominal interest rate is a reflection of the
expected inflation rate.
• The Real Interest Rate is equal to the
Nominal Interest Rate minus the Expected
Inflation Rate.
Q&A
• 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 and 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.