Money Growth and Inflation Notes

Money Growth and Inflation

Learning Objectives

• Explain how inflation is a monetary phenomenon using graphs.
• Define the Quantity Theory of Money.
• Calculate money supply, velocity, price level, and real output using the Quantity Theory of Money.

Essential Knowledge

• Inflation results from rapid increases in the money supply. Deflation results from rapid decreases in the money supply for a sustained period of time.
• When the economy is at full employment, changes in the money supply affect price levels but not real output.
• In the long run, the money supply growth determines the inflation rate according to the Quantity Theory of Money.

Equation of Exchange

The equation of exchange is represented as:

$MV = PY$

Where:

• $M$ = Money Supply
• $V$ = Velocity of Money
• $P$ = Price Level
• $Y$ = Real Output

Key points to note:

1. $P mes Y$ represents nominal GDP.
2. The equation $MV = PY$ always holds true.

Long-Run Conclusions

1. In the long run, the price level changes directly with changes in the money supply. Thus money supply and price level are directly proportional.
2. In the long run, changes in the money supply do not affect real output or employment.

Example: Calculate Real GDP

Given:

• $M$ = $1,800
• $V$ = 2
• $P$ = 1.2

Using the equation of exchange:

$MV = PY$

$1,800 mes 2 = 1.2 mes Y

$3,600 = 1.2Y

$Y = \$3,600 ÷ 1.2 = \$3,000$

Real GDP = $3,000

Example: Calculate Velocity of Money

Given:

• $M$ = $2,000
• Nominal GDP = $3,800 (Remember nominal GDP is $P mes Y$)

Using the equation of exchange:

$MV = PY$

$2,000 mes V = \$3,800

$V = \$3,800 ÷ \$2,000 = 1.9$

Velocity of Money = 1.9

Concept Check

If the money supply remains constant and both the price level and real output increase, velocity will increase.

Long-Run Impact of Increased Money Supply

In the long run, if the money supply increases:

• Price Level: Increase
• Real Output: No Change
• Employment: No Change

Key Takeaways

• $MV = PY$ describes the relationship between money supply, velocity, price level, and real output.
• The Quantity Theory of Money explains that long-term inflation is tied to money supply growth.
• In the long run, changes in the money supply do not affect real output or employment (Neutrality of Money).