Prof. Yoram Landskroner

1
MONEY, OUTPUT AND PRICES

• Prof. Yoram Landskroner

2
QUANTITY THEORY OF MONEY

• Hypothesizes relation between money, the general
  price level and aggregate output in the economy
• Where the most common measure of aggregate output
  is the Gross Domestic Output (GDP)the value of
  all final goods and services produced in the
  economy during a year
• Measures of general price level
• GDP price deflator nominal GDP divided by real
  GDP
• Consumer Price index (CPI) weighted average
  price of a basket of goods and services bought
  by a typical urban household

3

• Real versus Nominal terms
• Nominal values measured in current prices
  ,nominal GDP
• Real constant or beginning of year prices, real
  GDP, measure of quantities of goods and services
• The difference between the two is the change in
  the price level

4

• The starting point (Fisher 1911) the relationship
  between money supply (quantity of money) M
• and value of spending on goods and services
  during a year
• PY
• Where
• P General price level
• Y Real output of goods and services (quantity)
• PY is therefore nominal output (nominal GDP)

5

• The link between the two is the Velocity of
  Money, V
• V is the velocity of money,the rate of turnover
  of money
• We can now establish the exchange equation
• MV PY
• This is tautology
• Value of money expensed on goods and services
  during a year equals the value of goods and
  services when purchased

6
Early/Classical QTM

• To convert identity to theory of the
  determination of nominal output, have to explain
  the determination of
• velocity (institutional arrangements in the
  economy) and
• money supply (central and commercial banks)
• Early/Classical QTM
• Assumes
• 1. V is constant in the short run
• 2. V is independent of M
• 3. Y is at full employment

7

• Results and implications
• Changes in nominal output are determined solely
  by changes in the money supply
• There is a proportional relationship between
  money and prices
• M (Y/V) P
• Where (Y/V) is a constant.
• Thus an increase in money (quantity) supply is
  the only cause for an increase in the price level
  (inflation)

8

• Because the model relates money and aggregate
  output it can also be taken to be a theory for
  the demand for money
• M kPY
• Where k1/V is a constant
• This is also known as the Cambridge equation
• The demand for money is determined by the
  transactions generated by nominal output

9
Modern QTM

• Following data collected after WWII assumptions
  of the old QTM were relaxed
• 1. V may vary even in the short run (it declined
  sharply during the Great Depression)
• 2. Changes in M induce changes in V in the
  opposite direction
• 3. Assumption of full employment may be
  unrealistic (Y lt Y)

10

• Implications and issues
• An increase in M may cause an increase in Y
  and/or P or a decline in V
• Issue of speed of adjustments of aggregates to
  changes in M (P vs. Y)
• Increase in M increases expenditure (MV) or
  nominal product (PY)?

11

• Is velocity constant or can the QTM be used to
  predict inflation?
• M2 velocity remained stable in the 1980s
• This lead the Federal Reserve to use the QTM to
  predict inflation
• In the early 1990s M2 growth declined but it
  settled down again in the late 1990s
• THE END