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MACROECONOMICS CHAPTER 5: Inflation: Its Causes, Effects, and Social Costs
Macroeconomics 11th Edition By N. Gregory Mankiw
The quantity theory of money ● Examines the macroeconomic effects of
monetary policy
● Tells us how the quantity of money is related to
other economic variables, such as prices and
incomes
● Is the leading explanation for how money affects
the economy in the long run.
Transactions and the Quantity Equation The quantity equation
● The link between transactions and money
● Money ×Velocity=Price× Transactions
● M × V =P ×T
Quantity equation analysis
● T = the total number of transactions (goods or
services are exchanged for money) during a
period of time
● P = the price of a typical transaction
● PT = total number of dollars/ money exchanged
for that time
● M = the quantity of money in the economy.
● V= the transactions velocity of money,
measures the rate at which money circulates in
the economy. In other words, the number of
times a dollar bill changes hands in a period of
time.
○ Example = 5 times per year
From Transactions to Income To study the role of money in the economy
● T (the number of transactions)→ too hard
to measure irl
● Replace by Y (the total output of the economy)
Updated quantity equation
● Y = the amount of output
○ Real GDP
● P = the price of one unit of output
○ GDP deflator
● PY = the dollar value of output
○ nominal GDP
● Money ×Velocity=Price× Output
● M × V =P ×Y
● V = the income velocity of money
○ Tells us the number of times a dollar bill
enters someone’s income in a given
period of time
The Money Demand Function and the Quantity Real money balances
Equation ● The quantity of money in terms of the quantity of
goods and services it can buy.
, MACROECONOMICS CHAPTER 5: Inflation: Its Causes, Effects, and Social Costs
Macroeconomics 11th Edition By N. Gregory Mankiw
● This amount = Money (M) / Price (P)
● They measure the purchasing power of the
stock of money
○ Example: the real money balances
are 10 loaves of bread→ at current
prices, the stock of money in the
economy can buy 10 loaves.
A money demand function
● An equation that shows the determinants of the
quantity of real money balances people wish to
hold
● ( M / P) d=kY
● k = a constant that tells us how much money
people want to hold for every dollar of income.
● This equation states that → the quantity
demanded of real money balances is
proportional to real income.
The link between money demand & money velocity
● The demand for real money balances ( M / P) d
must equal the supply (M/P)
● So M / P=kY
● So M (1/k )=PY
● Quantity equation → MV =PY where V =1 / k
● When (k) is large
○ People want to hold a lot of money for
each dollar of income
○ So (V) is small→ money changes
hands infrequently
● When (k) is small
○ People want to hold only a little money
for each dollar of income
○ So (V) is large→ money changes
hands frequently
The Assumption of Constant Velocity The quantity theory of money
● The quantity equation definition of velocity (V):
○ The ratio of nominal GDP (PY ) to the
quantity of money (M)
● The quantity theory of money:
○ We make an additional assumption
→ the velocity of money is constant
○ Now it’s a useful theory about the effects
of money after
The assumption of constant velocity and the money
supply
● The quantity equation→ now a theory of
what determines nominal GDP.
● M V =PY
○ V =¿ velocity is fixed
● So, a change in (M) must cause a proportionate
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