CHAPTER 14
Money and the Economy
In Chapters 12 and 13 we learned about the monetary system in the United States, both how
money is created and how the Federal Reserve conducts its monetary policy. Now that we
have established these foundations, we want to find out how changes in the money supply
affect the economy. In particular, we want to study the relationship between the money
supply and inflation, analyzing the process that links monetary increases to inflation and
determining how strong this causal link is.
CHAPTER OBJECTIVES
Upon completing this chapter, your students should be able to:
1.
Explain the equation of exchange.
2.
Make predictions based on the simple quantity theory of money.
3.
Explain monetarism in an ADAS framework.
4.
Identify the causes of oneshot inflation.
5.
Identify the cause of continued inflation.
6.
Explain the difference between the liquidity, income, pricelevel, and expectations
effects and explain how each affects the interest rate.
KEY TERMS
•
velocity
•
income effect
•
equation of exchange
• pricelevel effect
•
simple quantity theory of money
• expectations effect
•
oneshot inflation
• nominal interest rate
•
continued inflation
• real interest rate
•
liquidity effect
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Chapter 14
CHAPTER OUTLINE
I.MONEY AND THE PRICE LEVEL
—The MVPQ model addresses the
relationship between money and price level and between money and nominal GDP.
A.The Equation of Exchange
—The
equation of
exchange
simply states
M
×
V
≡
P
×
Q
where M = the money supply (usually thought of as M1), V = the velocity of
money (defined below), P = the price level, and Q = real output, or Real GDP.
1.What Is “Velocity”?—
Velocity is the
number of times the average dollar
is spent to buy final goods and services in a given year
. We measure velocity
by dividing nominal GDP by the money supply, that is
V
≡
GDP/M
2.Interpreting the Equation of Exchange
—The equation of exchange tells
us a number of things. In addition to its literal reading, it tells us that
M
×
V = (nominal) GDP
since P
×
Q = (nominal) GDP, and it also tells us that
Total spending (M
×
V)
≡
total sales revenues (P
×
Q)
B.From the Equation of Exchange to the Simple Quantity Theory of Money
—
velocity (V) and real output (Q) are effectively constant in the short run;
therefore, any change in the money supply (M) must cause a strictly proportional
change in the price level (P) and nominal GDP
. The
simple quantity theory of
money
predicts that changes in the money supply will bring about
strictly
proportional
changes in the price level as illustrated in Exhibit 1. For realworld
examples of the relationship between money and inflation, see the
Economics
Around the World
feature “Money and Inflation.” The examples in Exhibit 2
show the strong relationship between money supply growth and inflation.
C.The Simple Quantity Theory of Money in an ADAS Framework
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 Fall '08
 Richard
 Economics, Inflation, Interest Rates, Monetary Policy, Inflation rates, price level

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