Macro 5.3 - Money Growth and Inflation - Monetary Equation of Exchange & Quantity Theory of Money

Summary

In this video, Jacob Reed from ReviewEcon.com explains the Quantity Theory of Money and the Monetary Equation of Exchange. He discusses how inflation occurs when the money supply grows faster than real output, referencing historical cases like hyperinflation in Germany and Zimbabwe. The video breaks down the formula (M * V = P * Y), where M is the money supply, V is the velocity of money, P is the price level, and Y is real output. Reed emphasizes the impact of money supply changes on prices, real output, and inflation, and the importance of understanding this theory for economics exams.

Takeaways

• 😀 Inflation occurs when the money supply increases faster than real output, as explained by economist Milton Friedman.
• 😀 Hyperinflation happens when there is an extremely rapid increase in the money supply, as seen in historical cases like Germany in 1923 and Zimbabwe in 2008.
• 😀 The monetary equation of exchange is represented by the formula: M * V = P * Y, where M is the money supply, V is the velocity of money, P is the price level, and Y is real output.
• 😀 The velocity of money (V) measures how often a dollar circulates in an economy, reflecting its overall spending frequency.
• 😀 An example of a simple economy shows that increasing the money supply causes the price level to rise, assuming stable velocity and real output.
• 😀 The formula (M * V = P * Y) implies that nominal GDP is equal on both sides, which helps understand inflation and its connection to money supply changes.
• 😀 When the money supply increases but real output remains the same, only the price level rises, not real GDP, as shown in the AS-AD model.
• 😀 The stability of the velocity of money is a key assumption in the quantity theory of money, although long-term stability has been questioned in some instances.
• 😀 If the money supply doubles, nominal GDP must increase proportionally to maintain equilibrium in the equation, with a corresponding increase in the price level.
• 😀 Even if the velocity of money is not constant, the equation M * V = P * Y still holds true by definition, and real output changes can require proportional money supply adjustments.

Q & A

What is the Quantity Theory of Money?

The Quantity Theory of Money explains the relationship between the money supply and the price level. It suggests that inflation occurs when the money supply grows faster than real output. Milton Friedman famously stated that 'inflation is always and everywhere a monetary phenomenon,' meaning inflation is caused by too much money in circulation relative to the goods and services available.

How does the Quantity Theory of Money relate to inflation and deflation?

According to the Quantity Theory of Money, inflation happens when the money supply grows faster than real output. Conversely, deflation can occur when the money supply grows more slowly than the increase in real output. This theory emphasizes that money supply plays a key role in influencing the price level.

What is the significance of hyperinflation examples like Germany in 1923 and Zimbabwe in 2008?

Hyperinflation in these countries is an extreme example of how rapidly increasing the money supply can devalue a currency. In Germany in 1923, hyperinflation caused the value of money to plummet, leading to people using currency as toys rather than for transactions. Zimbabwe’s 2008 hyperinflation rate reached 89.7 sextillion percent, resulting in the collapse of their currency and the adoption of the US dollar.

What are the four variables in the Monetary Equation of Exchange?

The four variables in the Monetary Equation of Exchange are: M (money supply), V (velocity of money), P (price level), and Y (real output or real GDP). These variables are part of the equation MV = PY, which relates the money supply and velocity to the price level and real output.

How does the equation MV = PY relate to nominal GDP?

In the equation MV = PY, both sides represent nominal GDP. On the left side, M is the money supply and V is the velocity of money. On the right side, P is the price level and Y is real output. The equation shows that the total value of transactions in the economy (nominal GDP) is determined by both the money supply and the price level of goods and services.

What happens in the example with one dollar in circulation?

In the example, if one dollar circulates and is spent multiple times (on a candy bar, cookie, soda, and donut), the money supply remains the same (one dollar), but it is used multiple times to purchase goods. This illustrates how the velocity of money affects the overall economic activity, with one dollar generating multiple transactions.

What is the implication of doubling the money supply on the price level?

If the money supply is doubled while the velocity of money and real output remain constant, the price level must also double to maintain equilibrium in the equation MV = PY. This is a direct result of more money being available, leading to higher prices if output remains unchanged.

How does the increase in the money supply affect the AS-AD model?

In the AS-AD model, an increase in the money supply leads to lower interest rates, which stimulates investment and shifts the aggregate demand (AD) curve to the right. In the short run, this increases the price level and real output. However, in the long run, as wages and input costs rise, the short-run aggregate supply (SRAS) curve shifts left, restoring the economy to long-run equilibrium with a higher price level but unchanged real output.

What is the criticism regarding the stability of the velocity of money?

One criticism of the Quantity Theory of Money is that the velocity of money is not always stable, particularly in the long run. While the velocity of money might remain stable in the short run, historical data shows it can fluctuate, complicating predictions based solely on the theory.

How can the Quantity Theory of Money still hold true if the velocity of money is unstable?

Even if the velocity of money is unstable, the equation MV = PY still holds true by definition. If the velocity of money changes, it may require adjustments in the money supply or real output to maintain balance. For example, if real output increases, the money supply must also increase to avoid inflation, assuming velocity is stable.