202-T&C-11 - 1 Econ 202 Terms and Concepts 11 THE...

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Econ 202: Terms and Concepts 11: THE EQUATION OF EXCHANGE Clearly things that happen in the financial sector (the money markets) cause changes in the real sector. We need a model that allows us to predict and control monetary impact on real goods and services and prices. The model that we use is called the Equation of Exchange, and it is probably the earliest equation developed for market economies, pre-dating even Adam Smith's Wealth of Nations (1776), François Quesney's "tableau économique" (1758) and Sir William Petty's original presentation of supply and demand (1672). The model was developed by John Locke (1632-1704), who had a hand in the development of everything we associated with modern society - legal theory, economic theory, social theory, and empiricism. His two Treatises on Government profoundly influenced the US Constitution. P - general price level - since the equation describes the economy as a whole this is not the price of any individual good but the general price level as determined from a price index. Q - quantity of reall goods and services. Now, when we calculate GDP we sum all goods and and services at their current prices. So the PQ on the right hand side of the equation simply represents nominal GDP . We are in the "real sector" but the measurement we are taking is the nominal, current-year value of GDP. (Do not confuse this with real GDP, where nominal prices have been deflated to some base year price level.) If we multiply all the units of currency in circulation by the number of times each unit of currency changes hands - that is, gets spent - we have measured all the expenditures that have been made. One again, that measure represents expenditures at current year prices, which is just another way John Locke 1632-1704 portrait by Sir Godfrey Kneller public domain The Equation of Exchange MV = PQ money supply x money velocity = general price level x real goods and services The left hand side of the equation represents the monetary sector and the right hand side represent the real sector. To understand what the equation is telling us about the transmission of monetary policy to the real sector, we do need a firm grasp of the meaning of each term in the equation. M - money supply - units of currency in circulation. We will this to be M2, the monetary target of the Fed. V - money velocity - the number of times a unit of currency changes hand in a year. 1
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of saying nominal GDP. So the equation of exchange is an identity . It is true by definition that the money transactions must be equal to the purchases of goods and services that were made.
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