Quantity Theory Of Money Flashcards
Quantity theory of money assumptions first
Flexible prices, output and real variables are at their long run equilibrium.
General theory of QToM
Changes in money influence the general price level. (More money, more transactions, thus price change)
Quantity theory of money formula
MV= PT
M= money in circulation
V= velocity of circulation (transactions)
P=price
T=volume of transactions.
To make this for macro, we need to use output (Y) rather than transactions (T)
So what is the quantity theory equation with output, and how do we find λ?
MV=PY
Y=output (REPLACED T)
V is velocity of money (rather than velocity of circulations i.e transactions)
And then remember long run assumption (earlier) so rearrange by letting
M=λP so λ=Y/V
M=λP where λ=Y/V what does this show?
It shows the relationship between money supply and the general price level. M is a function of price
Is assumption of constant velocity of money reasonable (V)?
And 2 reasons why/not
No, Technology changes over time and so will V. E.g credit cards, mobile payments
No, natural events e.g pandemic causes people to hold more cash, reducing V.
We can also relate velocity of money to the interest rate through demand for money.
- Demand for money and the quantity theory: How can we express demand for money nominal and real?
- Then , how can we use the money market equilibrium
Md = kPy (nominal)
Md/P = ky (real: divide by P)
Where k is constant representing transaction technology and cost of holding money.
- MM equilibrium says
M/P = Md/P (supply=demand)
So M/P (supply) =kY (demand)
Which we can rearrange by x P and /k
M(1/k)=PY
Which is the QT equation if V=(1/k)
(MV=PY)
To comply with the original statement, k is dependent on the interest rate. high interest rate = low k, demand for money is low, less cash holding since cost of holding is high more spending= high V.
Low interest, high K, demand for money high since cheap/low opportunity cost of holding, so velocity high.
K is dependent on the interest rate. High interest=low k (since we reduce demand for money) and high V
What do we observe from this?
- What is K dependent on?
Velocity of money is inversely related to demand for money. (demand for money high=hold cash more=less spending=lower V)
- K is dependent on the internet rate, high r = low K
Money and inflation logs result if λ (or Y/V) constant vs not constant
Use M=λP and take logs.
If λ constant
% change in P depend on % in MS
If λ non-constant
% change in P = % change in MS + % Change in V - % Change in Y
Extra
So what is the reason we observe high monetary growth and high inflation
Seigniorage.
Seigniorage
Revenue from manufacturing of cash calculated as the difference between face value and production cost.
So when money demand rises, this arises the opportunity to earn additional revenue from printing more currency (notes and coins)
Should additional money generate rising prices, revenue produced is called inflation tax.
Why does seigniorage occur
when money demand rises.
Should additional money generate rising prices, revenue produced is called inflation tax.
(E.g more money demanded, so more printed, more spent, rising prices as a result of this printing)
If a country’s currency is used in other currency, they can earn seigniorage from the rest of the world.
Example?
US dollar used across the world. Vehicle currency.
Relationship between PREDICTED inflation and nominal interest rates (i) .
What equation shows this?
Fisher equation
i = r + πe
πe is expected inflation.
Fisher assumes r is fixed
