Knetwit #3 - Chapter 14 Notes: Velocity- indicates the...

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Chapter 14 Notes: Velocity- indicates the number of times per year that an “average dollar” is spent on goods and services. It is the ratio of nominal gross domestic product to the number of dollars in the money stock: Ø Velocity = Value of Transaction/Money Stock= Ø Nominal GDP/M = Ø P x Y/M The Equation of Exchange- states that the money value of GDP transactions must be equal to the product of the average stock of money times velocity. Ø Money Supply x Velocity = Nominal GDP Ø M x V = P x Y The Quantity Theory of Money- assumes that velocity is constant. Nominal GDP is proportional to the money stock. 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. Ø %ΔM + %ΔV = %ΔP + %ΔY It is this factor that most directly undercuts the usefulness of the quantity theory of money as a guide for monetary policy. In the previous chapter, we learned that expansionary monetary policy, which increases bank reserves and the money supply, also decreases the interest rate. But if interest rates fall, other things being equal, velocity (V) also falls. Thus, when the Fed raises the money supply (M), the product M x V should increase by a smaller percentage than does M itself. Velocity is not a strict constant but depends on such things as the efficiency of the financial system and the rate of interest. Only by studying these determinants of velocity can we hope to predict the growth rate of nominal GDP from knowledge of the growth rate of the monetary supply. Monetarism- a mode of analysis that uses the equation of exchange to organize and analyze macroeconomic data. Monetary policy is not the only type of policy that affects interest rates. Fiscal policy does, too. Specifically, increases in government spending or tax cuts normally push interest rates up, whereas restrictive fiscal policies normally pull interest rates down. Because a rise in G pushes interest rates higher, and hence deters some investment spending, the increase in the sum C + I + G + (X-IM) is smaller than what the oversimplified multiplier formula predicts. REASONS WHY THE OVERSIMPLIFIED FORMULA OVERSTATES THE MULTIPLIER: 1. It ignores variable imports, which reduce the size of the multiplier. 2. It ignores price-level changes, which reduce the size of the multiplier. 3. It ignores the income tax, which reduces the size of the multiplier. 4. It ignores the rising interest rates that accompany any autonomous increase in spending, which also reduce the size of the multiplier. Conventional types of fiscal policy action, such as changes in G or in persona taxes, probably affect aggregate demand much more promptly than do monetary policy actions. Policy lags are normally much shorter for monetary policy than for fiscal policy
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This note was uploaded on 04/07/2009 for the course ECON 20091_ECO taught by Professor Mohammadsafarzadeh during the Fall '09 term at USC.

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Knetwit #3 - Chapter 14 Notes: Velocity- indicates the...

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