Monday, September 26, 2011

The Equation of Exchange

CFA Level 1 - Macroeconomics

The Quantity Theory of Money
The quantity theory of money proposes that the quantity of money and price levels increase at the same rate in the long run. This concept is demonstrated by the equation of exchange.
The Equation of ExchangeThe equation of exchange is comprised of the money stock, M, multiplied by the velocity of money, V. The velocity of money is the number of times money turns over (spent as part of a final good or service) during the year.
Therefore, we get the expression:
Formula 4.4
M × V= P × Q = Total Spending or GDP
P represents the price level, and Q represents the quantity of goods and services produced. This equation is referred to as the equation of exchange. It is the basic equation used by monetarists - economists who believe that fluctuations in the money supply are the chief source of fluctuations in real economic output and that the major cause of inflation is excessive growth in the money supply.
If quantity and velocity are basically constants, increasing the money supply will just lead to an increase in prices (inflation). The Quantity Theory of Money holds that in the long run, because quantity and velocity are not changed by the money supply, a percentage increase in the money supply will lead to a corresponding increase in the price level. However, if monetary policy can influence velocity or quantity, monetary policy can be useful.
The equation of exchange can be converted into the demand for money function:
Formula 4.5
Md = (P × Q) / V = Y / V
Where Md is the demand for money and Y is nominal GDP. From the monetarist's viewpoint, the demand for money is related to nominal GDP, not interest rates (the Keynesian viewpoint). 
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