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14CHAPTERMoney and the Economy

Money and the Price Level

Classical economists believed that changes in the money supply affect the price level in the economy. Their position was based on the equation of exchange and on the simple quantity theory of money.

The Equation of Exchange

The equation of exchange is an identity stating that the money supply

(𝑀) multiplied by velocity of circulation (𝑉) must be equal to the price

level (𝑃) times Real GDP (𝑄).

𝑀𝑉 ≡ 𝑃𝑄

where ≡ means “must be equal to.” This is an identity, and an identity is

valid for all values of the variables.



Velocity is the average number of times a unit of money ($1 or Tk.1)

is spent to buy final goods and services in a year.

For example, assume an economy has only five Tk. 1 bills. Suppose

that over the course of the year, the first Tk.1 bill changes hands 3

times; the second, 5 times; the third, 6 times; the fourth, 2 times; and

the fifth, 7 times.

Given this information, we can calculate the average number of

times a unit of money changes hands in purchases. In this case, the

number is 4.6, which is velocity.



In reality, counting how many times each dollar changes hands

is impossible; so calculating velocity as we did in our example is

impossible. In reality, we use a different method.

We compute velocity using the equation of exchange:

𝑉 ≡𝑃𝑄

𝑀≡𝐺𝐷𝑃

𝑀



The equation of exchange can be interpreted in different ways:

1. The money supply multiplied by velocity must equal the price level

times Real GDP: 𝑀 × 𝑉 ≡ 𝑃 × 𝑄

2. The money supply multiplied by velocity must equal GDP: 𝑀 × 𝑉 ≡𝐺𝐷𝑃 (because 𝑃 × 𝑄 ≡ 𝐺𝐷𝑃).

3. Total spending or expenditures of buyers (measured by 𝑀𝑉) must

equal the total sales revenues of business firms (measured by 𝑃𝑄):

𝑀𝑉 ≡ 𝑃𝑄


From the Equation of Exchange to the Simple Quantity

Theory of Money

The equation of exchange is an identity, not an economic theory. To turn it

into a theory, we make some assumptions about the variables in the

equation. Many eighteenth-century classical economists, as well as

American economist Irving Fisher (1867–1947) and English economist

Alfred Marshall (1842–1924), made the following assumptions:

1. Changes in velocity are so small that for all practical purposes velocity

can be assumed to be constant (especially over short periods of time).

2. Real GDP, or 𝑄, is fixed in the short run.



Theory of Money

With these two assumptions, we have the simple

quantity theory of money: If 𝑉 and 𝑄 are constant, then

changes in 𝑀will bring about strictly proportional

changes in 𝑃.

In other words, the simple quantity theory of money

predicts that changes in the money supply will bring

about strictly proportional changes in the price level.



Theory of Money

How well does the simple quantity theory of money predict?

The answer is that the strict proportionality between changes

in the money supply and changes in the price level does not

show up in the data (at least not very often).

Generally, though, the evidence supports the spirit (or

essence) of the simple quantity theory of money: the higher

the growth rate in the money supply, the greater the growth

rate in the price level.



Theory of Money

To illustrate, we would expect that a growth rate in the money

supply of, say, 40 percent would generate a greater increase

in the price level than, say, a growth rate in the money supply

of 4 percent.

Generally, this effect is what we see. For example, countries

with more rapid increases in their money supplies often

witness more rapid increases in their price levels than do

countries that witness less rapid increases in their money

supplies.


The Simple Quantity Theory of Money in an AD–AS

Framework

AD curve in the Simple Quantity Theory of Money

Recall that one way of interpreting the equation of exchange is that the

total expenditures of buyers (MV) must equal the total sales of sellers

(𝑃𝑄). So,

𝑀𝑉 = 𝐴𝑔𝑔𝑟𝑒𝑔𝑎𝑡𝑒 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒𝑠 (𝐴𝐸).

However,

𝐴𝐸 = 𝐶 + 𝐼 + 𝐺 + 𝑋 −𝑀

→ 𝑀𝑉 = 𝐶 + 𝐼 + 𝐺 + 𝑋 −𝑀



Framework

AD curve in the Simple Quantity Theory of Money

At a given price level, anything that changes 𝐶, 𝐼, 𝐺, 𝑋 or 𝑀changes

aggregate demand and thus shifts the aggregate demand (𝐴𝐷) curve. If

𝑀𝑉 equals 𝐶 + 𝐼 + 𝐺 + 𝑋 −𝑀, then a change in the money supply (𝑀)

or a change in velocity (𝑉) will change aggregate demand and therefore

lead to a shift in the 𝐴𝐷 curve.

In other words, aggregate demand depends on both the money supply

and velocity. But in the simple quantity theory of money, velocity is

assumed to be constant. Thus, only changes in the money supply can

shift the 𝐴𝐷 curve.



Framework

The AS curve in the simple quantity theory of money

In the simple quantity theory of money, the level of Real

GDP is assumed to be constant in the short run. The AS

curve is vertical at that constant level of Real GDP.



Framework

AD and AS in the simple quantity theory of money


Dropping the Assumptions that 𝑽 and 𝑸 Are Constant

If we drop the assumptions that velocity (𝑉) and Real GDP (𝑄) are

constant, we have a more general theory of the factors that cause

changes in the price level. In this theory, changes in the price level

depend on three variables:

1. Money supply

2. Velocity

3. Real GDP

Let’s again start with the equation of exchange: 𝑀 × 𝑉 ≡ 𝑃 × 𝑄

If the equation of exchange holds, then:

𝑃 ≡𝑀 × 𝑉

𝑄


Dropping the Assumptions that 𝑽 and 𝑸 Are Constant

This last equation shows that the price level depends on the money

supply, velocity, and Real GDP.

What kinds of changes in 𝑀, 𝑉, and 𝑄 will bring about inflation (an

increase in the price level), ceteris paribus?

Inflationary tendencies: 𝑀 ↑, 𝑉 ↑, 𝑄 ↓

What will bring about deflation (a decrease in the price level), ceteris

paribus?

Deflationary tendencies: 𝑀 ↓, 𝑉 ↓, 𝑄 ↑

Inflation

In everyday usage, the word inflation refers to any increase in the price

level. Economists, though, like to differentiate between two types of

increases in the price level: a one-shot increase and a continued

increase.

One-Shot Inflation

One-shot inflation can be thought of as a one-shot, or one-time,

increase in the price level. More precisely, if price level increases but

not on a continued basis, we call the price increase ‘one-shot inflation’.

Suppose the CPI for years 1 to 5 is as follows:

Inflation

One-shot inflation: demand-side induced

Price levels that go from 𝑃1 to 𝑃2 to 𝑃3 may seem like more than a one-

shot increase. But because the price level stabilizes (at 𝑃3), we cannot

characterize it as continually rising. So the change in the price level is

representative of one-shot inflation.

Inflation

One-shot inflation: supply-side induced

20

Inflation

Continued Inflation

Continued inflation can be demand-side induced (Demand-pull

inflation) or supply-side induced (Cost-push inflation)

Demand-pull inflation is an inflation that results from an initial

increase in aggregate demand.

Demand-pull inflation may begin with any factor that increases

aggregate demand, e.g., increases in the quantity of money,

increases in government purchases, or cuts in net taxes, an

increase in exports etc.

21

Inflation

Demand-pull inflation

This Figure illustrates

the start of a demand-

pull inflation.

Starting from full

employment, an

increase in aggregate

demand shifts the AD

curve rightward.

22

Inflation

Real GDP

increases, the

price level rises,

and an

inflationary gap

arises.

The rising

price level is

the first step

in the

demand-pull

inflation.


23

Inflation

Demand-pull

inflation

This Figure

illustrates the

money wage

response.

The higher level

of output means

that real GDP

exceeds potential

GDP—an

inflationary gap.

24

Inflation

Demand-pull

inflation

The money

wage rises and

the SRAS curve

shifts leftward.

Real GDP

decreases back

to potential

GDP but the

price level rises

further.

25

Inflation

Demand-pull

inflation

This Figure

illustrates a

demand-pull

inflation spiral.

Aggregate

demand keeps

increasing and the

process just

described repeats

indefinitely.

26

Inflation


Although any of several

factors can increase

aggregate demand to start a

demand-pull inflation, only

an ongoing increase in the

quantity of money can allow

it to continue.


occurred in the United States

during the late 1960s and

early 1970s.

27

Inflation

Cost-push inflation is an inflation that results from an

initial increase in costs.

There are two main sources of increased costs:

An increase in the money wage rate

An increase in the money price of raw materials, such as

oil.

28

Inflation

Cost-push inflation

This Figure

illustrates the start

of cost-push

inflation.

A rise in the price

of oil decreases

short-run

aggregate supply

and shifts the

SRAS curve

leftward.

29

Inflation

Cost-push

inflation

Real GDP

decreases and

the price level

rises—a

combination

called stagflation.

The rising price

level is the start

of the cost-push

inflation.

30

Inflation

Cost-push inflation

The initial increase in costs creates a one-shot rise in the

price level, not a continued inflation.

To create continued inflation, aggregate demand must

increase; which can happen because the Government or

the central bank may react to the rise in unemployment by

increasing aggregate demand.

31

Inflation

Cost-push

inflation

This Figure

illustrates an

aggregate demand

response to

stagflation, which

might arise because

the CB stimulates

demand to counter

the higher

unemployment rate

and lower level of

real GDP.

32

Inflation

Cost-push

inflation

The increase in

aggregate

demand shifts

the AD curve

rightward.

Real GDP

increases and

the price level

rises again.

33

Inflation

Cost-push

inflation

This Figure

illustrates a

cost-push

inflation spiral.

34

Inflation

If the oil producers raise the price of oil to try to keep its relative price higher, and the Govt. or the central bank responds with an increase in aggregate demand, a process of cost-push inflation continues.

Cost-push inflation

occurred in the United

States during 1974–

1978.

Cost-push

inflation

Inflation

Inflation is always and everywhere a monetary

phenomenon

The money supply is the only factor that can continually increase

without causing a reduction in one of the four components of total

expenditures (consumption, investment, government purchases, or

net exports).

This point is important because someone might ask, “Can’t

government purchases continually increase and so cause continued

inflation?” This is unlikely for two reasons.

Inflation


phenomenon

1. Government purchases cannot go beyond both real and political limits.

The real upper limit is 100 percent of GDP. No one knows what the

political upper limit is, but it is likely to be substantially less than 100

percent of GDP. In either case, once government purchases reach

their limit, they can no longer increase.

2. Some economists argue that government purchases that are not

financed with new money may crowd out one of the other expenditure

components. For example, for every additional dollar government

spends on public education, households may spend $1 less on private

education.

Inflation


phenomenon

The emphasis on the money supply as the only factor that can

continue to increase and thus cause continued inflation has led

most economists to agree with Nobel Laureate Milton Friedman

that “inflation is always and everywhere a monetary phenomenon.”

Inflation

Can You Get Rid of Inflation with Price Controls?

Say, in country A, the government uses price control to stem

inflation. Price ceilings (price control mechanism) are always set

below equilibrium price.

So, if the government has set up price ceiling say for good 𝑖 at $4

where the equilibrium price is $8 then there will be a shortage for

good 𝑖, and very likely, people will line up to buy it. Let’s say that, on

average, 25 people stand in line If the equilibrium price goes up to,

say, $12 (due to, say, increased demand) but the price ceiling for the

good remains set at $4, people will continue to line up to buy the

good, but now the lines will be longer. The average line may stretch

out to, say, 50 people.

So how is inflation felt in a country that imposes and maintains price

ceilings? The answer is in the length of the lines of people: the

longer the lines, the higher the inflation rate.

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