Quantity Theory of Money - Video Tutorials & Practice Problems

Quantity Theory of Money

Alright. So now let's look into the quantity theory of money. So the quantity theory of money, what it does is it connects the money supply? So the amount of money available in the economy with the level of prices? So there's gotta be some connection with how much money is available and how the price level is going to be in the economy. And that's what this theory is trying to connect. So it's a very simple equation. We've got M. Times V. Equals P times why? So let's go ahead and define what all of these are. M. Is our money supply. And remember we're trying to connect the money supply to the level of prices in the economy. So let's see what these variables do. So our money supply. The amount of money available in the economy set by the fed and then the velocity of money velocity of money. It's kind of a funny term. But what does that mean? It's the average number of times each dollar is spent in the money supply. So think about when you go to the store and you spend a dollar, you you bring a dollar and you buy a candy bar and then the store goes and they take that money and they pay their employees and the employee goes and buy some groceries at the store and then that dollar goes from the store and gets spent somewhere else, right? So the same dollar doesn't just get spent once and get retired. No it keeps circulating, it goes from one hand to another and keeps getting spent keeps getting spent, right? So the velocity of money is the average number of times each dollar is going to be spent. Okay. Generally in a year, how many times will this dollar that I have in my pocket? How many times will I spend it? Someone else spend it? How many times will it change hands during one year? That's the velocity of money. Next we have P which is the price level in the economy. And remember we're trying to connect the money supply to the level of prices and finally, why is going to be our GDP? Okay GDP in the economy? And we'll say Real GDP because remember Real GDP keeps prices constant and then we'll multiply it by the price level to get to the current prices in the economy. Alright, so let's go through this example together real quick and we'll see how this money supply works and then we'll go into more detail in the next video. So in 2014 the money supply equaled $2.8 trillion, while real GDP totaled 16 trillion price deflator was 1.09, calculate the velocity of money. So remember we've got m times v The money supply times the velocity equals the price level, times the level of real GDP. Okay, so let's go ahead and put in what we know they told us the money supply is 2.8 trillion we'll just leave it as 2.8 And we're calculating the velocity of money, they told us the price deflator, price, the price level is 1.09. What does that 1.09 mean that means that prices are one point oh nine what they were in the original year? In our base year. So if we were thinking something cost us a dollar in the base year, well this year, that same product would cost us a dollar and nine cents. Okay, so the prices have gone up since the since the base year And real GDP, it also told us is 16 trillion. Okay, so we've got all of our variables except the velocity. Let's go ahead and solve for the velocity here. If we divide both sides by 2.8, Well we'll have solved for the velocity. So let's go ahead and snag our calculators. Let's do some quick math here. So 1.09 times 16 Divided by 2.8. So that tells us the velocity. I'm gonna I'm gonna round it off to six here. I'm just gonna say it's approximately six, it was like six point something and it comes out to approximately six. So that says each dollar changes hands approximately six times per year, Okay, per year. So each time you spend a dollar it's going to be spent on average six times each dollar in the economy. Right? So that's how the theory works. You'll be given some variables and you can solve for the last variable. Um But let's go ahead and think a little bit more of the implications of the quantity theory.

Quantity Theory of Money and Inflation

So cool thing happens here if we hold the velocity of money constant. Okay so the quantity theory of money argues that the velocity is constant and it kind of makes sense if you think about the average times of dollars spent, remember that's what the velocity is talking about. How often is that money spent? How often is it changing hands? Well it depends on things that do not change that often. A lot of a lot of times when money changes hands it's on things that are kind of regularly scheduled. How often you get paid right every time you get paid? Well that's pretty consistent. Regardless of the price level, what's happening in the economy, you're generally gonna be paid every two weeks every friday. However your schedule is that's not gonna change based on uh macroeconomic events. How often you go to the grocery store right? How often you you make these general purchases, how often you pay your bills. These things are pretty constant, right from person to person, they're gonna be constant. Of how often they're doing that. So the velocity of money more or less doesn't change too much. It's not like you start spending a lot of cash at one point and then slow down how much spending in your cash you do. You kind of have this kind of average rate that you're spending cash. So a mathematical rule allows us to take the equation we've been using M times V. Equals p times Y. To analyze inflation. So without getting too much into the math. We we can make this relationship where if we analyze the changes in this these variables. Well we can set up the same calculation as additions here. So the change in the money supply uh plus the change in the velocity. So notice we've changed for multiplication to addition. Okay now I don't want to get into the details of the mathematics, we don't need all of that. We just um can can know that uh equation that's set up like this with the multiplication. Well if we want to analyze the the differences, the changes in the variables, well we can add them together like this. Okay so they this is a mathematical identity that we can do here. So the change in the money supply plus the change in velocity is equal to the change in prices plus the change in GDP. So we just said that we're gonna hold velocity constant, right velocity is gonna be constant. So the change in the velocity of money is gonna be the same from year to year. If there was 66 was the velocity of money last year. Six will be the velocity of this year. So the change in the velocity is zero. There's no change in the velocity. So that leaves us with the other three variables, the change in the money supply equals the change in the price level plus the change in GDP. Okay so let's go ahead and let's let's um get the price level by itself. Let's change let's move the change in G. D. P. To the other side of the graph of the equation here and we'll have the change in the money supply minus the change in G. D. P. Equals the change in prices. And what is the change in prices? This is inflation, right? The change in prices is inflation. If if that's if that's a positive number if prices are higher this year than they were last year. Well that's an increase in the prices, it's inflation there. So what does this tell us? Look down here where we can make our conclusions? I'll get out of the way if the money supply grows faster than real GDP. So in this situation we have we have something going on where we've got the change in money supply minus the change in GDP equals a change in price levels. So in this case the money supply is growing faster, right? The money supply is growing faster than real GDP. Well we're gonna see inflation right? There's more money available and it's gonna increase the prices in the economy. Right? So this is kind of the connection we're making from the quantity theory of money. This is the conclusions we can make is uh this this balance between the money supply and the price level. So if the money supply grows slower than real GDP. So in this case we've got the same equation changing money supply changing why changing prices. Well now there's the same amount of money, but there's more goods available leading to lower prices, which is what we call deflation, There's gonna be a little a decrease in the prices in this case. And finally, if they grow at a constant rate, money supply growing at the same rate as GDP, so they're growing equally well. If those changes are growing equally there there's not going to be a change in the price level, what's going to then there will be uh what are we gonna call this? We're gonna be called this constant prices, right? There's not gonna be a change in the prices, there will be stable prices will say better, There will be stable prices, prices in the economy. Okay, so we can use that quantity theory of money equation two ways we can use it as that multiplication and we can solve for one of the variables or we can use the changes in the variables to describe how the money supply and GDP affect inflation. Alright, let's go ahead and move on to the