Wednesday, May 3, 2017

Equation of Exchange (Quantity Theory of Money)

Quantity Theory of Money
Equation of Exchange

Lorenzo in Hong Kong @ AIS wants to know about
Equation of Exchange and how has it been tested.
Monetarists believe that inappropriate monetary policy will cause macroeconomic instability.
M*V = P*Q
(Money Supply (times) the Velocity of Money) = (Price * Quantity or Nominal GDP)

Monetarists want the V (velocity of money) to be stable
(no sudden increases in the money supply)

1) If the PL is 4 and the velocity of money is 8, 
real output is $4,000 then the money supply must be?

M*V = P*Q
M(?) * 8 = 4 * $4,000
then the MS must be $2,000,
($2,000 * 8) = (4 * $4,000)

If the money supply rises faster than the rate of growth then we will have inflation
If the Money Supply doubles the Price Level doubles

1995 - 0 questions

2000  #40
Answer - A - Income velocity of money increased

Remember that the Equation above is an (Identity), 
meaning that both sides must equal each other.
If the MS decreases and the NGDP doesn't change the only thing that could have changed is the Velocity of money must have decreased.

2005 #58 

Answer - E the price level will increase
The Velocity of Money and the RGDP are often considered constant, so if the MS increases and Velocity and RGDP are constant the only thing that could have increased is the Price level.

2008 #21
Answer - B Nominal National Incomes
Recognise that National Incomes are the 
Y = Incomes on the bottom of your AD/AS graphs.

If velocity is stable, meaning that the factors affecting it change gradually and predictably, changes in M lead directly to changes in Nominal GDP (PxQ)
2010 #16

Answer - A increase in nominal output
Nominal Output = Nominal GDP

If the economy is expected to grow at 2 percent in a given year, the Fed should allow the money supply to increase by 2 percent. The Fed should be bound to fixed rules in conducting monetary policy because discretionary power can destabilize the economy.­
2012 #59
Answer - E Long Run RGDP

Practise Test Question (No idea where it is from)
Answer - A Monetarists believe V is stable

People have a stable desire to hold money relative to other financial assets. 
If the money supply is stable and V, velocity is stable then total spending is stable

From Chinese Booklet (no idea where it came from)
Answer - A.
If the money supply increases at the same rate that velocity falls, the NGDP is unaffected.

Answer - E
If the demand for money decreases the NIR will decrease, the money supply is constant so no change.