Econ2102_Lecture4_handout

The velocity of money exogenously given constant

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Unformatted text preview: quantity theory of money allows us to make the connection between money and inflation. •  adds demand deposits to the money base –  M2 •  adds savings accounts and money market account balances to M1 Money stock Velocity of money Price level Real GDP 11 8/4/11 •  Velocity of money –  The average number of times per year that a unit of money is used in a final-goods transaction •  The equation implies that the amount of money used in purchases is equal to nominal GDP (flow of money=flow of goods and services). •  In the quantity theory of money –  Real GDP is assumed as exogenously given –  Determined by real forces. •  In other words: The Classical Dichotomy, Constant Velocity, and the Central Bank •  The classical dichotomy –  States that, in the long run, the real and nominal sides of the economy are completely separate. •  The velocity of money –  Exogenously given constant –  Assumed to be constant (or stable function of exogenous variables) over time •  In other words: Bar over the Y means exogenous. No time subscript 12 8/4/11 •  The money stock –  Determined by the central bank’s setting for money supply –  Monetary policy is exogenously given •  In other words: The Quantity Theory for the Price Level •  To solve the model •  Prices will rise as a result of –  Plug all the exogenous variables –  Solve for the price level –  Increases in the money stock –  Decreases in real GDP •  In the long run, the key determinant of the price level is the money stock....
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