Week 6 Flashcards
What is the equation of exchange?
The equation of exchange states that the quantity of money multiplied by the number of times this money is spent equals nominal income.
Get by multiplying both sides of velocity equation by M.
What are the determinants of velocity
The two factors that determine velocity are the institutional and technological factors in the economy. Take a long time to implement so in short term velocity is constant.
Example more credit card transactions equals higher velocity
What concept explores the link between money supply and total amount of spending on final goods and services in economy?
The Velocity of money which measures how many times $1 is spent buying total amount of goods and services in economy.
Velocity = total output / quantity of money
How is the quantity theory a theory of the demand for money
Quantity theory is a theory of the demand for money because it tells us how much money is held for a given amount of nominal spending.
What does dividing both sides of the equation of exchange by velocity yield
An equation of the demand for money
Money demand = velocity constant X PY (output)
Equation tells that transactions generated by fixed PY determines quantity of money demanded
Theory suggests money demand is function of income
How does the equation of exchange become the quantity theory of money
Because of the fact velocity is constant in the short run it transforms equation of exchange into quantity of money
P x Y = M x velocity constant
Equation states that nominal income is solely determined by movements in quantity of money
How can quantity theory determine price level
Classical economists believed Y could be treated as constant.
By dividing both sides of quantity equation by Y constant price level can be determined
P = M x velocity constant / output constant
States changes in quantity of money lead to proportional changes in price level
How is the quantity theory a theory of inflation
The inflation rate equals the growth rate in the money supply minus the growth rate of aggregate output
What are the 3 motives behind the demand for money in Keynes Liquidity Preference Theory?
1: Transactions Motive
2: Precautionary Motive
3: Speculative Motive
What is the transactions motive
People hold money as medium of exchange to carry out everyday transactions.
Is proportional to income
What is the precautionary motive
People hold money as a cushion against unexpected wants
It is proportional to income
What is the speculative motive
People choose to hold money as a store of wealth
As interest rate on alternative assets demand for money falls due to opportunity cost
What is the liquidity preference function
What Keynes developed to put the 3 motives together of holding real money balances into an equation.
States demand for real money balance is negatively related to nominal interest rate and positively related to real income
What is the relationship between liquidity preference theory and velocity
Keynes believed Velocity was not constant due to the fact when interest rates go up or down velocity follows in the same footsteps and because interest rates have substantial fluctuations so must velocity
