Economics: The Quantity Theory of Money $1.98 (2 credits)

This lesson is part of the following series:

www.thinkwell.com/student/product/economics. The full course covers economic thinking, markets, consumer choice, household behavior, production, costs, perfect competition, market models, resource markets, market failures, market outcomes, macroeconomics, macroeconomic measurements, economic fluctuations, unemployment, inflation, the aggregate expenditures model, banking, spending, saving, investing, aggregate demand and aggregate supply model, monetary policy, fiscal policy, productivity and growth, and international examples.

Steven Tomlinson teaches economics at the Acton School of Business in Austin, Texas. He graduated with highest honors from the University of Oklahoma and earned a Ph.D. in economics at Stanford University. Prof. Tomlinsons academic awards include the prestigious Texas Excellence Teaching Award given by the University of Texas Alumni Association and being named Outstanding Core Faculty in the MBA Program several times. He has developed several instructional guides and computerized educational programs for economics.

Weve talked about output, weve talked about unemployment, and weve talked about inflation. Now its time to construct a story that begins to fit together all of these variables in the macroeconomy. In this discussion, were going to be building what I think is the simplest model in macroeconomics. Its great though because it shows a simple relationship between money, output, and prices — three of the most important variables in describing the macroeconomy.

The model is called the quantity theory of money, and it begins with a very simple insight. That is, all the shopping that people are doing in our economy has to be paid for somehow. Anytime youre doing shopping, you are either handing someone cash or writing a check. Even if youre paying with a credit card, youre eventually settling that account with cash or a check. So the shopping thats done in the economy depends critically on the amount of money there is available to make that shopping happen. This is the insight behind the quantity theory of money.

Let me build an equation that shows the quantity theorys story. Lets start with the gross domestic product of the economy. The gross domestic product has two components — the prices people pay for the output, real goods and services that they guy. If you multiply prices times quantity, and add them up, you get the total shopping bill for the economy, the real gross domestic product — the market price of all final goods and services that are produced in the economy in a year.

Now, how do people pay for this stuff? Whenever they go and they buy these goods and services, what are they using to settle the transaction? Theyre using money, and by money, we mean currency and checks. These are what are called transactions instruments, or the payment system. If we take all the cash and checks that are out there in the economy, then weve got the money supply. The money supply is what people use for shopping. If you want to know whether somethings money or not, answer this question: Could you use it to pay the pizza delivery guy when he brings your pizza? Checks, yes; cash, yes; usually not credit cards; certainly not shares of stock. I mean, that other stuff isnt money, but all cash and currency is.

Then, theres this other matter of velocity; that is, in the United States right now, the gross domestic product is close to $9 trillion. The money supply, however, is only $1 trillion. What does that tell you? It tells you that theres about nine times as much value in shopping being done as there is money to make that shopping possible. That means that the money has to be circulating in the economy. A given dollar bill is spent again and again and again, on average nine times a year. That nine times is what we call the velocity of money. The velocity of money is defined as the average number of times that a dollar bill in our economy is spent and re-spent in the course of a year.

So this equation that Ive written down, which is sometimes called the quantity equation, is really just a matter of accounting. All the shopping thats done in the economy has to be paid for with money. And since theres a limited stock of money, a given dollar bill is spent again and again in the course of a year. In the U.S. economy, $9 trillion worth of shopping, $1 trillion worth of money — a given dollar bill spent again and again, nine times.

Now, to turn this into a theory about the way the economy works, lets make an assumption about velocity. Lets suppose that people spend and re-spend money at a constant rate. Thats not exactly realistic. When interest rates are high, people want to get by with less money, because they want to put more of their wealth in bonds and stocks and mutual funds and savings accounts, and other forms that arent money. However, lets suppose for the sake of simplicity that people spend money at a constant rate — anytime you get money, you typically spend it within a certain amount of time. Well, if thats true, if the velocity of money is constant — and Ill hold it constant by putting a bar over the top of it, this red bar means that velocity doesnt change — if thats the case, then any change in the money supply has to show up as a change in gross domestic product — which means either a change in the price level, a change in output, or a change in both.

Let me take a very simple numerical example in which the economy produces one product — cars, and thats our gross domestic product is the amount of money thats spent in our economy on cars in a year. Suppose theres $1.00 in the economy, so the money supply is $1.00. And lets suppose that the velocity of money is 2 — and youll see where that comes from in just a moment. Well, if the price of a car is $2.00, and we have one car produced in our economy, then the gross domestic product is $2.00, which means that our dollar bill has to be spent on average two times in a year to pay for this shopping.

Lets start with those numbers, and lets ask the question, What would happen in this economy if we increased the money supply? Now, with Garys help, were going to print a little bit of extra money, and were going to find out what happens to the variables we care about, what happens to prices and output when money increases. So Gary, lets put a little bit of paper in our printing press, and see if we cant get some money out. Great, thank you very much. So now weve doubled our money supply; weve gone from $1.00 to $2.00 worth of money. And now that we have $2.00 in the money supply, with a velocity of 2, somethings got to give over here. There are two things that could happen.

Well, one thing that could happen is that the extra money makes credit easier to get. Since weve pumped more money into our economy, banks may be more likely to make you a loan, because the money isnt as scarce as it was before. If credit is easier to get, businesses are likely to expand and produce more output, and real GDP — that is why the output of the economy could increase. Thats possibility number one.

So we have two cars, at $2.00 apiece equals $4.00 of gross domestic product, which is our $2.00 money supply multiplied by the velocity of 2. These $2.00 circulate to create this gross domestic product. So one possibility is an increase in the money supply working through the banking system, through the credit markets, lowered the interest rate, makes credit easier to get, encourages businesses to expand, and gives us a higher real output.

The alternative is that output doesnt change at all, and the price level simply increases from $2.00 to $4.00. That is, with more money in the economy, people are spending a higher quantity of nominal money on one car, which is going to drive up its price. That is, the price of the car is bid up, there is no more real output, and therefore the increase in the money supply is purely inflationary. All it does is result in an increase in the price level.

So, two possibilities: an increase in the money supply if velocity is constant can either increase real output, or it can increase the price level. At this point, youve got a very good question, and that is, How do we know which one is going to happen? How do we know whether an increase in the money supply is going to lead to an expansion in the real economy, or simply create inflation? The answer depends on where we start. That is, when we increase the money supply, are we at a point in the economy where theres slack, where there are unemployed workers, where there is unemployment among raw materials, where theres stuff thats not being used. If weve got slack, if were in a place of unemployment in the economy, an increase in the money supply is more likely through its effect on the credit markets, to increase real output, and give us this outcome. That is, an increase in the money supply is likely to provoke an expansion in the real economy.

However, again, this depends on the fact that wed be starting in a recession, or in a period of unemployment. This is what happened in the United States in the early 1990s. We were in a recession, and the Federal Reserve, through its cooperation with the banking systems, increased the money supply, encouraged banks to lend more freely, businesses expanded, and the economy grew, and real output increased.

On the other hand, if were already at full employment, and we cant produce anymore output — that is, if unemployment is low, if raw materials are already fully employed, if were right up against the speed limit of the economy, if were at the non-accelerating inflationary rate of unemployment -if were at that point, then pumping more money in isnt going to get you any more stuff, because theres no more stuff to make. Were right at the capacity of the economy; therefore, the increase in the money supply only increases the price level. This is the case frequently. In fact, the Fed is afraid — the Federal Reserve system is concerned that the U.S. economy might be at that place right now, and that the growth rate of the money supply, if it were to increase, would not give us extra output, but only spark inflation.

Now the classical economists focused on the capacity of the economy. They believe that output was in the long run fixed and that it couldnt increase. Therefore, in the long run, if output cant increase, then any change in the money supply, in the long run, is purely going to affect prices; theres going to be no change in output. So a reduction in the money supply is going to lower prices; an increase in the money supply is going to increase prices.

In the classical view of the economy, money doesnt affect real variables. It affects only nominal variables. That is, the money supply, which is measured in money, a nominal variable, influences prices, the other nominal variable, without any affect on output, the real variable. So in the classical view of the quantity theory of money, velocity is stable, output is fixed, and increases in the money supply affect only the price level. Nominal variables influence only nominal variables.

Now a minute ago Gary came in and printed money for us, and this is what happens in a lot of governments that dont have alternatives for financing public goods. That is, if the only way you can finance public goods is by printing more money, youre likely to provoke inflation in your economy. This is called the inflation tax, where people throughout the economy pay for the governments spending in the form of higher prices for all goods and services, because the government is spending by printing money; and printing money, in the long run, is going to be purely inflationary.

So, see, with this quantity theory of money, were able to come up with a simple relationship among some very important macroeconomic variables — money, the price level, and the real economy. Well be building some more complicated models as our discussion of macroeconomics progresses, but its great to have a simple model to start with, because it does explain a lot.

Economic Fluctuations: Unemployment and Inflation

Inflation

The Quantity Theory of Money Page [3 of 3]