Survey of Economics – Quantity Theory of Money and Inflation

These flashcards cover the quantity theory of money, velocity, inflation, deflation, and hyperinflation, including definitions, formulas, calculations, and long-run implications.

What is the fundamental quantity equation in the quantity theory of money?

M × V = P × Y

According to the quantity theory, what occurs if the money supply grows faster than real GDP while velocity is constant?

The price level rises, creating inflation.

In which time horizon is the quantity theory most useful for explaining inflation?

The long run.

What do we call extremely high rates of inflation that can reach hundreds or thousands of percent per year?

Hyperinflation.

Why might a government allow hyperinflation to happen?

To finance spending that exceeds tax revenue by having the central bank increase the money supply much faster than GDP grows.

If the money supply grows 8 % per year and real GDP grows 3 % per year with constant velocity, what is the inflation rate?

5 %.

If the money supply grows 8 %, real GDP grows 3 %, and velocity grows 2 %, what is the resulting inflation rate?

7 %.

Define the velocity of money.

The average number of times each dollar in the money supply is used to purchase goods and services included in GDP during a given period.

With constant velocity, what effect does an increase in the money supply have, according to the quantity theory?

It raises nominal GDP (and therefore the price level if real output is unchanged).

What is deflation?

A fall in the overall price level.

What did Professor Spencer mean when he said printing money will keep the deflation "wolf from the door"?

Raising the money supply faster than GDP growth increases the price level and prevents deflation.

Why can deflation cause consumers to delay purchases and set off a self-reinforcing downward spiral?

Consumers expect further price declines, reduce current demand, and the lower demand pushes prices down even more.

How did printing 1.5 billion Confederate dollars during the Civil War likely affect their value?

It produced high inflation that severely reduced the currency’s purchasing power.

During Germany’s 1920s hyperinflation, which group benefited to some extent?

People with debt, because they repaid with money worth much less.

Which of the following statements about hyperinflation are true: (1) caused by rapid money growth, (2) people avoid holding money, (3) can be hundreds or thousands of percent per year?

All of them are true.

Given a money supply of $2,400, a price level of 1.42, and real GDP of $14,000, what is the velocity of money?

8.28

In Irving Fisher’s quantity equation, what does V equal?

V = (P × Y) / M, the average number of times a dollar is spent on goods and services.

What does long-run evidence show determines the rate of inflation?

The growth rate of the money supply.

When is inflation likely to occur if velocity is constant?

When the money supply grows faster than real GDP.

According to the quantity theory of money, inflation results when:

The money supply grows faster than real GDP.

What key assumption about velocity underlies the quantity theory of money?

Velocity is constant (or stable) in the long run.

If velocity is 3 and the money supply is $600 million, what is nominal output (P × Y)?

$1.8 billion.

Write the formula used to calculate velocity.

V = (P × Y) / M

When velocity is constant, how can we express the inflation rate using the quantity equation?

Inflation rate = Growth rate of the money supply – Growth rate of real output.

In which run is the link between changes in the money supply and inflation strongest?

The long run.

is caused by central banks increasing the money supply far faster than real GDP grows.

Hyperinflation.