Exam (elaborations)
MONEY AND BANKING NOTES TILL LEC 11
- Course
- ECON 231 (ECON231)
- Institution
- New York University
It is an elaboration and compilation of all lecture notes till lecture 11 for exam purposes.
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LECTURE 8Quantity theory of money - increases with volume of transactions and average time the money
is held , Decreases with average time money changes hands which is velocity of money
Income velocity of money - average times each dollar changes hands per year
V= Y/M (years^-1) = INCOME VELOCITY OF MONEY
Nominal upon nominal or real upon real , income upon money stock
Transaction velocity - actual times each dollar changes hand per year
Total nominal transactions upon money stock - T/M (year ^-1)
But T is harder to measure than Y, so rarely used.
“Velocity” usually means Income Velocity.
Quantity equation - MV = Py which is money supply where multiplied by velocity is equal to
price level and income
if the money supply increases (M ↑), and assuming the velocity (V) and real output (y) remain
constant, the price level (P) must rise to maintain the equation's balance. This reflects a direct
relationship between the money supply and price level — an increase in money in circulation
leads to inflation.
If the velocity of money increases (V ↑), and assuming the money supply (M) and real output
(y) remain constant, the price level (P) will rise. A higher velocity means money is changing
hands more quickly, which can drive up prices because each unit of money is being used for
more transactions in the same period.
If real output increases (y ↑), with the money supply (M) and velocity (V) held constant, the
price level (P) will decrease. This is because a larger amount of goods and services (y) is being
, produced without an increase in the money supply, leading to downward pressure on prices, i.e.,
deflation. Increases in M or V tend to increase the price level (inflationary effect).
Increases in y (real output) tend to reduce the price level (deflationary effect)
Dynamic form of Q equation
ΔM/M + ΔV/V ≈ ΔP/ P + Δy/y (REMEMBER)
π = μ + ΔV/V − g
Inflation = Money Growth + Velocity Growth − Real Income Growth
High inflation is usually accompanied by high money growth
Why might V change?
If the interest rate goes up, the opportunity cost of holding money rises. People are more likely
to reduce their cash holdings (lower money demand, or mD), preferring to hold interest-earning
assets. As a result, the velocity of money (V) increases because people are holding less money
and spending it more quickly. Money circulates faster in the economy.
When the nominal interest rate (i) decreases, the opportunity cost of holding money falls. People
are more inclined to hold more cash or liquid assets (higher money demand, or mD), since the
return on alternative assets is lower. Consequently, the velocity of money (V) decreases because
people are holding onto their money longer, reducing the speed at which money circulates in the
economy.
In short, Higher interest rates (i ↑) → People hold less money (mD ↓), and money circulates
faster (V ↑).Lower interest rates (i ↓) → People hold more money (mD ↑), and money
circulates more slowly (V ↓).
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