AP Economics: Money, Inflation, and the Quantity Theory

Equation of Exchange

MV = PY, where M is money supply, V is velocity, P is price level, and Y is real output (real GDP). It shows that total spending equals total value of goods and services produced.

Velocity of Money

The number of times a dollar is spent in the economy in a given period. In the quantity theory, velocity is assumed to be stable.

Quantity Theory of Money

The idea that growth in the money supply leads to inflation, assuming velocity is stable and real output grows slowly.

Inflation Approximation

Inflation ≈ Money supply growth − Real GDP growth.

Inflation

A steady increase in the general price level that reduces purchasing power, hurts savers, and benefits borrowers.

Deflation

A decrease in the general price level that can cause consumers to delay spending and slow economic growth.

Hyperinflation

Extremely rapid inflation that makes money nearly worthless and creates severe economic instability.

Disinflation

A decrease in the rate of inflation, meaning prices are still rising but at a slower pace.

Fisher Effect

The idea that nominal interest rates adjust to expected inflation, shown by the formula i = r + πᵉ.

Nominal Interest Rate

The interest rate quoted by banks that does not account for inflation.

Real Interest Rate

The purchasing power gain from lending or investing, calculated as nominal interest rate minus inflation.

Seigniorage

Revenue the government earns by printing money, which often leads to inflation if overused.

Money Neutrality

The concept that in the long run, changes in the money supply affect only nominal variables like prices, not real output or employment.

Menu Costs

The costs businesses incur when changing prices, such as updating menus, catalogs, or computer systems.

Who Benefits from Inflation?

Borrowers and asset holders benefit because they repay loans with money that is worth less.

Who Is Hurt by Inflation?

Lenders and people with fixed incomes because their purchasing power declines.

Money Supply Increase — What Happens?

An increase in money supply leads to inflation, higher nominal interest rates (Fisher Effect), reduced purchasing power, and higher menu costs in the long run.

Money Supply in the Long Run

In the long run, money is neutral, so changes in the money supply affect prices but not real GDP.