Quantity Theory of Money

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Quantity Theory of Money
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Why should the Quantity Theory of Money (QTM) be
Introduced?

• The QTM can be viewed as a special case of the
  economic theory behind the LM curve.
• The equation behind the LM curve is that the real
  supply for money (M/P)s is equal to the real
  demand for money, and the demand of money depends
  on the transaction demand (i.e., it depends
  positively on output Y) and the speculative
  demand (i.e., it depends negatively on interest
  rate r)

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Why should the Quantity Theory of Money (QTM) be
Introduced?

• A simple version of the QTM ignores the effects
  of interest rate and postulates that M/P kY,
  where K is a positive constant.
• The advantage of the QTM is that it explicitly
  brings in the relationship between the price
  level and the money supply and output.
• This is important because as remarked by Milton
  Friedman, Inflation is always and everywhere a
  monetary phenomenon. Without the QTM, it is hard
  to discuss inflation.

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Empirical Relevance of the QTM

• How well does the QTM fit the empirical data,
  given that we ignore the effects of interest
  rate? Some variants of the QTM have been applied
  to many economies, including Hong Kong and China.
  It is known that the QTM works very well.
• To empirically test the model, usually we need to
  modify the QTM a bit.

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Empirical Relevance of the QTM

• M/P kY can be expressed in the form of
• m p y,
• where m is the change in M,
• p is the change in P, and
• y is the change in Y.
• (Note that the growth rate of k must be zero
  because it is a constant.)
• Alternatively, p m y, i.e., inflation is
  positively related to growth rate in money supply
  and negatively related to output growth.

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Empirical Relevance of the QTM

• More advanced theories tell us that the real
  demand for money is better described by M/Pe,
  where Pe is expected inflation rate. This is
  because we dont know what inflation is going to
  be, and so we can only form expectation of it. In
  practice, expected inflation rate depends on past
  values of actual inflation. Due to this
  complication, more sophisticated versions of the
  QTM assume that inflation depends on current and
  past values of the growth rates of M and Y.
• This version of the QTM can explain more than 99
  of the changes in prices in Hong Kong.

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Earlier Versions of the QTM

• Historically, the QTM has another form
• MV PY, where V is the velocity of money.
  It is supposed to measure how often the money
  stock turns over in each period. Alternatively,
  we can write V nominal GDP/nominal money
  supply, i.e., V PY/M.
• MV PY should be treated as an identity,
  rather than an equation, because by the
  definition of V, it must always true. When there
  are changes in M, P, or Y, then V may have to
  adjust.

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Earlier Versions of the QTM

• Empirically, the V in the identity above need not
  be a constant.
• If we impose the assumption that V is a constant,
  then we have the QTM, which can be tested
  empirically. The new version of the QTM is M/P
  kY, where k 1/V.