Chapter 20: Quantity Theory, Inflation, and the Demand for Money

Vocabulary and key concepts from Chapter 20 regarding the velocity of money, quantity theory, Keynesian liquidity preference, and the causes of inflation.

Velocity of money ($V$)

The average number of times per year that a dollar is spent in buying the total amount of final goods and services produced in the economy, defined by the formula $V = \frac{PY}{M}$.

Equation of exchange

The mathematical identity that relates the quantity of money ($M$) and velocity ($V$) to the price level ($P$) and aggregate output ($Y$): $MV = PY$.

Irving Fisher

The economist who argued that velocity is determined by the institutions in an economy that affect the way individuals conduct transactions and is fairly constant in the short run.

Quantity theory of money

A theory stating that nominal income or nominal spending ($PY$) is determined solely by movements in the quantity of money ($M$), assuming velocity is constant.

Demand for money ($M^d$) - Fisher

A theory suggesting money demand is purely a function of nominal income ($PY$), expressed as $M^d = kPY$ where $k = \frac{1}{V}$, and that interest rates have no effect on money demand.

Classical economists

A group of economists who believed that wages and prices are completely flexible and that aggregate output ($Y$) remains at the full-employment level ($\bar{Y}$) during normal times.

Quantity theory of inflation

A theory derived from the equation of exchange where the inflation rate ($\pi$) equals the growth rate of money minus the growth rate of aggregate output: $\pi = \%∆M - \%∆Y$.

Milton Friedman

The economist famous for the statement "Inflation is always and everywhere a monetary phenomenon" regarding the long-run relationship between money growth and inflation.

Government Budget Constraint

An identity showing that government spending equals tax revenue plus the change in the monetary base ($\Delta MB$) plus the change in government bonds held by the public ($\Delta B$).

Monetizing the debt

A method of financing government spending where the central bank conducts an open market purchase to buy bonds, leading to an increase in the monetary base ($MB$) and the money supply.

Hyperinflation

Periods of extremely high inflation consisting of more than $50\%$ per month, such as the example seen in Zimbabwe in the 2000s.

Keynesian Liquidity Preference Theory

John Maynard Keynes’s theory identifying three motives for individuals to hold money: the transactions motive, the precautionary motive, and the speculative motive.

Transactions motive

A component of Keynes’s theory where individuals hold money to carry out everyday transactions, which is proportional to income.

Precautionary motive

A motive for holding money as a cushion against unexpected wants, which Keynes argued is proportional to income.

Speculative motive

A motive for holding money as a store of wealth; it is negatively related to the nominal interest rate ($i$) because the interest rate represents the opportunity cost of holding money.

Liquidity preference function

The formula $\frac{M^d}{P} = L(i, Y)$ stating that the demand for real money balances is negatively related to the nominal interest rate ($i$) and positively related to real income ($Y$).

Inflation risk

A variable in the demand for money; as it increases, money becomes relatively more risky and less desirable, causing money demand to fall.

Inflation hedges

Alternative assets to money that are used to protect wealth against inflation risk.