Fiat money evolves from commodity money as long as

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Unformatted text preview: personal notice deposits at banks M2+: Sum of M2 plus all deposits and shares at trust companies, mortgage loan companies, credit unions, and Caisses Populaires M3: Sum of M2 plus fixed- term deposits of firms at banks The quantity equation: Money (M) x Velocity (V) = Price (P) x Transactions (T). In this equation, M is quantity of money, V is the transactions velocity of money, T is the number of times a year that goods or services are exchanged for money, and P is the price of a typical transaction. To transform the above equation for income, it becomes: Money (M) x Velocity (v) = Price (P) x Output (Y). In this equation, Y is real GDP, P is the GDP deflator, M is the money supply, and V is the income velocity of money. We use this version of the quantity equation. Real money balances: M/P, the quantity of money in terms of the quantity of goods and services it can buy. Money demand function shows the determinants of the quantity of real money balances people wish to hold. A simple money demand function is (M/P)d = kY, where k is a constant that tells us how much money people want to hold for every dollar of income. Higher income leads to a higher demand for real money balances. A simple rearranging of this equation leads to M(1/k) = PY, which means that MV = PY where V = 1/k. This shows that when people want to hold a lot of money for each dollar of income (k is large), money changes hands infrequently (V is small) and vice- versa. The quantity theory of money assumes that V is constant, which, while not perfect, provides a useful approximation to the truth in many situations. Page 8 of 52 Jessica Gahtan Prof: Mokhles Hossain Macroeconomics ECON2000 Fall 2013 The quantity theory states MV¯,=PY. Therefore, a change in the quantity of money (M) must cause a proportionate change in nominal GDP (PY). The factors of production and the production function determine real GDP (Y), the money supply determines nominal output (PY), and the price level (P) is the ratio of nominal output to real output. Because velocity is fixed, any change in the supply of money leads to a proportionate change in nominal GDP. Because the factors of production and the production function have already determined real GDP, the change in nominal GDP must repre...
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