MACRO14 - Chapter 14 The Debate over Monetary and Fiscal...

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Chapter 14 The Debate over Monetary and Fiscal Policy Velocity and the Quantity Theory of Money Velocity - indicate the number of times per year that an “avg dollar” is spent on goods and services. The ratio of nominal GDP to the number of dollars in the money stock. o Velocity = nomical GDP/money stock o indicates the speed at which money circulates. Velocity = value of transactions = nominal GDP = P x Y Money stock M M Equation of Exchange states that the money value of GDP transactions must be equal to the product of the avg stock of money times velocity. o M oney supply x V elocity = P x Y (nomincal GDP) The quantity theory of money transforms the equation of exchange from an arithmetic identity into an economic model by assuming that changes in velocity are so minor that velocity can be taken to be virtually constant. o Assumes that velocity is (approx) constant. In that case, nominal GDP is proportional to the money stock. But in reality it is not so because V can simultaneously fall to prevent the product MxV from rising. Equation of exchange in growth-rate form. o % M + % V = % P + %Y o Some Determinants of Velocity Two important factors that decide whether a dollar will be used to buy goods and services whatever times a year. Efficiency of the Payments System Essentially the incentive to limit cash holdings thus depends on the ease and speed with which it is possible to exchange money for other assets. (computerized banking increases velocity ) Interest Rates the higher the interest rate the greater the opportunity cost of holding money. Higher int. rates, smaller cash balances. Existing money supply circulates faster and velocity rises. It is this factor that most directly undercuts the usefulness of the quantity theory of money as a guide for monetary policy. Expansionary monetary policy, which increases bank reserves and the money supply, also decreases the interest rate. But if the int. rates fall other things being equal, V also falls. Thus when the Fed raises M, the product MxV should incrase by a smaller percentage than does M itself.
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