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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 finalgoods
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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 Three '10
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 Macroeconomics, Unemployment

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