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Topic 7

The document discusses the quantity theory of money which states that money supply and price level are directly proportional. It explains that excess money creation causes inflation and that the impact of money supply changes depends on employment levels. The growth of money supply determines price level growth in the long run. Several calculations are shown illustrating the relationships.

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Gwen Stefani Daugdaug
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© © All Rights Reserved
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18 views

Topic 7

The document discusses the quantity theory of money which states that money supply and price level are directly proportional. It explains that excess money creation causes inflation and that the impact of money supply changes depends on employment levels. The growth of money supply determines price level growth in the long run. Several calculations are shown illustrating the relationships.

Uploaded by

Gwen Stefani Daugdaug
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 8

TOPIC 7

MONEY GROWTH AND INFLATION

Money is an economic
unit that functions as a
generally recognized
medium of exchange for
transactional purposes
in an economy. Money
originates in the form of
a commodity, having a
physical property to be
adopted by market
participants as a medium of exchange. Money, also sometimes called Currency, can
be defined as anything that people use to buy goods and services.

THE 3 FUNCTIONS OF MONEY


• Medium of exchange: an item buyer gives to sellers when they want to
purchase goods and services.
• Unit of account: the yardstick people use to post prices and record debts
• Store of value: an item people can use to transfer purchasing power from
the present to the future.

QUANTITY THEORY OF MONEY

An economic theory called the “quantity theory of money” indicates that


excess money creation is the underlying cause of inflation. This version of

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theory was first formulated by a Scottish philosopher David Hume during the
18th century and the recent proponent was Milton Friedman and Irving Fisher.

Quantity theory of money states that money supply and price level in an
economy are in direct proportion to one another. When there is a change in
the supply of money, there is a proportional change in the price level and vice-
versa.

• It tells how the price level is determine and why it changes over time.
• The quantity of money determines its value.
• The inflation is cause by the growth of money.

THE IMPACT OF CHANGES IN THE MONEY SUPPLY WILL DEPEND ON WHETHER OR


NOT THE ECONOMY IS AT FULL EMPLOYMENT

Central Bank is an institution that can influence output by increasing the money
supply. It might seem like the quantity theory of money contradicts because when
the money supply increases only the price level change. The important assumption
that drives the result is that output is fixed. This might be true in the long-run, but
not in the short-run. In the short-run, an increase in the money supply, decreases
the nominal interest rate, which increases investment and real output. However,
according to the self-correcting mechanism, the accompanying inflation will
eventually lead to a decrease in short-run aggregate supply (SRAS). The decrease
in SRAS returns the economy to full employment and a new permanently higher
price level. (Full employment is an economic situation in which all available labor
resources are being used in the most efficient way possible and embodies the

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highest amount of skilled and unskilled labor that can be employed within an
economy at any given time.)

The impact of a change in the money supply on real output ultimately depends on
the shape of the aggregate supply. If the aggregate supply curve is vertical (as it is
assumed to be in the long run) then an increase in the money supply will only
impact inflation. If the aggregate supply curve is relatively flat, then there might
be large increases in output that result from an increase in the money supply and
relatively little impact on the price level.

THE GROWTH OF THE MONEY SUPPLY DETERMINES THE GROWTH OF THE PRICE
LEVEL IN THE LONG RUN

The quantity theory of money treats money as neutral. That doesn’t mean that
changes in the money supply have no impact. Rather, “neutral” means that
changes in the money supply have no impact on one variable in particular - real
output. In the long run, real output will depend on resources and technology, not
the money supply. This means that changes in the price level (and therefore the
rate of inflation) depend primarily on changes in the money supply.

CALCULATION BASED ON QUANTITY EQUATION THEORY

Where:

• M – refers to the money supply


• V – refers to the Velocity of Money, which measures how much a single
peso of money supply spend contributes to GDP. It is also a rate at which
money changes hands.
• P – refers to the prevailing price level

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• Y – refers to the quantity of goods and services produced in the
economy. The real value of national output (real GDP)

FORMULA:

VxM=PxY

PROBLEM:

The economy has enough labor, capital, and land to produce Y = 800 bushels of rice
and V is constant. In 2008, MS = $2000 and the P = $5/bushel.

• Compute real GDP and Velocity in 2008.

REAL GROSS DOMESTIC PRODUCT:

RGDP = P x Y

= 5 x 800

RGDP = $4000

VELOCITY:

PxY
V =---------
M
5 x 800
V = ------------
2000

V=2

IMPLICATION: The average dollar was used in two transactions.

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The economy has enough labor, capital, and land to produce Y = 800 bushels of
rice. V is constant. In 2008, MS = $2000 and the P = $5/bushel. For 2009, the State
increases MS by 5%, to $2100.

a. Compute the 2009 values of real GDP and P. Compute the inflation rate for
the year 2008 to 2009.

ANS:

RGDP:

RGDP = P x Y

= 5 x 800

RGDP = $4000

PRICE LEVEL:

VxM=PxY

VxM
P = -----------
Y

2 x 2100
= -------------
800

4200
= -----------
800

P2 = $5.25

INFLATION RATE:

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P2 – P1
INFLATION RATE = ---------- x 100
P1

5.25 - 5
INFLATION RATE = ------------ x 100
5

0.25
= -------- x 100
5

INFLATION RATE = 5%

IMPLICATION: When Velocity of money and the Output is constant, while the
Money Supply is increasing - the Price as a result is also increasing while the value
of money is decreasing. The inflation rate however, is equal to the increase rate
of money supply.

b. Suppose technology progresses which cause Y to increase to 824 in 2009.


Compute 2008 to 2009 inflation rate.

ANS:

PRICE LEVEL:

VxM=PxY

VxM
P = -----------
Y

2 x 2100
= -------------
824

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4200
= -----------
824

P2 = 5.10

INFLATION RATE:

P2 – P1
INFLATION RATE = ---------- x 100
P1

5.10 - 5
INFLATION RATE = ------------ x 100
5

0.10
= -------- x 100
5

INFLATION RATE = 2%

IMPLICATION: When Velocity of money is constant while the Output and the
Money Supply is increasing - the Price as a result is also increasing a bit while the
inflation rate is decreasing.

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NOTA BENE:
HYPERINFLATION

• Hyperinflation is generally defined as inflation exceeding 50% per month.

• Prices rise when the government prints too much money. Hence, excessive growth
in the money supply always causes hyperinflation.

[end]

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