Quantity Theory of Money

Quantity Theory of Money

• Explains the long-run determinants of the price level.
• Explains the long-run rate of inflation.

Inflation, Deflation, and Hyperinflation

• Inflation: Increase in overall level of prices.
• Deflation: Decrease in overall level of prices.
• Hyperinflation: Extraordinarily high rate of inflation.

Core Principle

• The quantity of money available in the economy determines the value of money and the price level.
• The growth rate in the quantity of money available determines the inflation rate (in the long run).

Money Supply

• Determined by the Federal Reserve (The Fed) and the banking system.
  • The Fed prints money through open market operations.
  • Banks use a fractional-reserve system.

Quantity Equation

• The equation is expressed as: M × V = P × Y

  • Where:
    • M = Quantity of money.
    • V = Velocity of money.
    • P = Price level.
    • Y = Real GDP.

• Nominal GDP = P × Y, which follows from the circular flow concept.

• The equation can be understood as: Supply of dollars times their number of revolutions in a given period equals Nominal GDP.

Circular-Flow Diagram

• Households and Firms interact in:
  • Markets for Factors of Production:
    • Households provide labor, land, and capital.
    • Firms provide income (GDP) in the form of wages, rent, and profit.
  • Markets for Goods & Services:
    • Firms sell goods and services.
    • Households engage in spending (GDP) by buying goods and services.
    • Firms generate revenue (GDP) from sales.

Irving Fisher

• Developed the Quantity Theory of Money.
• Considered the greatest American economist of his time.
• Authored “The Purchasing Power of Money” in 1911.
• Original Monetarist.
• Famous for inventing the Rolodex.
• Known for providing stock market advice in 1929.

Empirical Observation

• Nominal GDP and the quantity of money have grown dramatically over time, while velocity has been relatively stable.

Growth Rate Evaluation and Simplification

• The relationship between growth rates is: Growth of M + Growth of V = Growth of P + Growth of Y
• Assuming V (velocity) is constant over time, the equation simplifies to: Growth of M = Growth of P + Growth of Y
• Rearranging the order, we get: Growth of P = Growth of M – Growth of Y
• Therefore, the Quantity Theory of Money can be expressed as: Inflation Rate = Growth of M – Growth of Y

Example

• If money supply growth is 10% and real GDP growth is 4%…
• The inflation rate will be 6% in the long run.
• The larger the money supply growth, the greater the inflation rate will be.
• Implication: The Fed controls money supply and, therefore, the long-run inflation rate.

German Hyperinflation

• Hyperinflation is defined as inflation that exceeds 50% per month.
• This leads to the price level increasing more than a hundredfold over the course of a year.
• Data on hyperinflation shows a clear link between the quantity of money and the price level.

Case Study: Germany in the 1920s

• Germany was devastated after WWI.
• Allies forced Germany to pay reconstruction costs.
• Currency Depreciation:
  • 1919: 1 U.S. $ = 4 German Marks
  • July 1922: 1 U.S. $ = 493 German Marks
  • Jan 1922: 1 U.S. $ = 17,792 German Marks
  • Nov 1923: 1 U.S. $ = 4.2 trillion German Marks (4,200,000,000,000)
• Cigarettes and Cognac were used instead of currency.

Graphical Representation of Hyperinflation

• During hyperinflations, the quantity of money and the price level move closely together.
• The strong association between these two variables is consistent with the quantity theory of money, which states that growth in the money supply is the primary cause of inflation.