Level 2 Inflation

Quantity theory of money

Quantity theory of money

MV=PQ

Quantity theory of money Variables

• M represents the money supply.

• V represents the velocity of money.

• P represents the price level.

• Q represents the quantity of goods and services exchanged in the economy (real GDP).

increase in Q (QTOM); impact on price level

Assuming Constant Money Supply (M) and Velocity (V): If the money supply (M) and the velocity of money (V) remain constant, an increase in the level of output (Q) will lead to a proportional decrease in the price level (P). In other words, prices will fall. This is because with a constant money supply, if the quantity of goods and services produced and exchanged (real GDP) increases, prices must decrease to maintain the equation of exchange

decrease in Q (QTOM) - Impact on Price Level

Assuming Constant Money Supply (M) and Velocity (V): If the money supply (M) and the velocity of money (V) remain constant, a decrease in the level of output (Q) will lead to a proportional increase in the price level (P). In other words, prices will rise. This is because, with a constant money supply, if the quantity of goods and services produced and exchanged (real GDP) decreases, prices must increase to maintain the equation of exchange.

decrease in money supply - impact on price level

Assuming Constant Velocity (V) and Output (Q): If the velocity of money (�V) and the quantity of goods and services (�Q) remain constant, a decrease in the money supply (�M) will lead to a proportional decrease in the price level (�P). In other words, prices will fall. This is because, with a constant velocity and output, a reduction in the money supply means there is less money available to facilitate the same level of economic transactions, leading to lower prices.

increase in money supply - impact on price level

Assuming Constant Velocity (V) and Output (Q): If the velocity of money (�V) and the quantity of goods and services (�Q) remain constant, an increase in the money supply (�M) will lead to a proportional increase in the price level (�P). In other words, prices will rise. This is because, with a constant velocity and output, there is more money available to facilitate the same level of economic transactions, leading to higher prices.

increase in velocity - impact on price level

Increase in Velocity and Other Variables Constant: If the money supply (�M) and the quantity of goods and services (�Q) remain constant, an increase in the velocity of money (�V) will lead to a proportional increase in the price level (�P). In other words, prices will rise. This is because each unit of money is being used more frequently to purchase goods and services.

decrease in velocity

Assuming Constant Money Supply (M) and Output (Q): If the money supply (�M) and the quantity of goods and services exchanged (�Q) remain constant, a decrease in the velocity of money (�V) will lead to a proportional decrease in the price level (�P). In other words, prices will fall. This is because, with a constant money supply and output, if money changes hands more slowly, it means the same amount of money is used for fewer transactions, which results in lower prices.

impacts of inflation ; purchasing power

Reduced Purchasing Power: Inflation erodes the purchasing power of money. As prices rise, each unit of currency buys fewer goods and services, leading to a decrease in the real value of money. This means that consumers can buy less with the same amount of money, and savers may see the value of their savings diminish.

impacts of inflation ; interest rates

Interest Rates: Central banks often respond to high inflation by increasing interest rates. Higher interest rates can lead to increased borrowing costs for businesses and consumers, potentially reducing economic activity and slowing down investment and spending.

impacts of inflation ; fixed income

Fixed-Income and Retirees: Inflation can be particularly challenging for those on fixed incomes, such as retirees living on pensions or fixed annuities. Their purchasing power may erode over time, making it harder for them to maintain their standard of living.

impacts of inflation ; international competitiveness

International Competitiveness: High inflation can erode a country's international competitiveness. When a country's currency depreciates due to inflation, its exports may become more attractive to foreign buyers, but it may also increase the cost of imports, potentially leading to trade imbalances.

boom - high inflationary pressure

a boom is a period of high economic activity. during a boom, resources and labour becomes scarce causing the cost of raw materials/labour to increase which will cause AS to decrease and result in cost push inflation. consumption and incomes/employment will also be high and cause AD to increase and result in demand pull inflation. both of these will result in high inflationary pressure.

recession - deflation

a recession is a period of low economic activity in which raw materials and labour becomes abundant, which decreases the costs of production, and increases AS, causing deflation. low employment and low consumption cause a decrease in AD, resulting in deflation.

business cycle - stages

boom/upswing/peak - high consumption, high investment, high employment

trough/recession - falling consumption, falling investment, falling employment

downturn/downswing - low consumption, low investment, low employment

recovery/upswing - increasing consumption, increasing investment, increasing employment

increase in M during boom

a boom is a period of high economic activity, so output is at or near full capacity, and the inflationary pressure of an increase in M (whilst V remains constant) cannot be absorbed by an increase in Q, so there is an increase in P, which results in an increase in inflation.

increase in M during trough

trough is a period of falling economic activity, so the output has spare capacity. this means Q can increase when the money supply increases, (whilst V remains constant) in order to absorb inflationary pressure.

depreciation on AD/AS

on AS ; increases cost of imported raw materials, which increases costs of production decreases due to reduced profitability, prices rise = costs rise

on AD ; exports are more price competitive, as exports rise, increase in net exports, which will increase AD