In this video you’ll learn about the quantity theory of money, the fisher equation and the
contrasting views of Keynesians and monetarists on the quantity theory of money.
The quantity theory of money examines the relationship between price changes and the
supply of money within an economy. A useful way to look at this relationship is the Fisher
Equation.
The Fisher Equation states that the money supply times its velocity of circulation is
equal to the price level times real GDP. Let’s look at the variables individually.
M represents the amount of money in circulation, or the money supply.
Velocity, or V, measures the frequency by which a unit of money is used across transactions,
or its velocity of circulation.
For example, if a $10 bill is used in 50 transactions in a given year, then its velocity is said
to be 50.
P represents the economy’s price level for a given period of time. It is measured as
an index against a base year, but the base year would have a value of 1, not 100.
Y represents the real value of finished goods and services sold in a given year. This means
that it is equal to GDP expressed in the prices of the base year, not the current year.
Therefore the money supply times the velocity of circulation will equal the price level
times the value of real GDP.
The identity shown will always hold as the value of what is purchased will equal the
value of output produced. Essentially, MV is equal to the value of purchases made in
an economy in a given period of time, where PY is equal to the value of final goods and
services sold in that same period of time.
It is always true that if something is sold, it has also been purchased. This is why these
values will always equal each other.
Another way to see this is to understand that the value of final goods and services purchased
in a year will be equal to nominal GDP. Equally, the value of final goods and services produced
and sold in a year will also be equal to nominal GDP. Now that we know this, we can try a slightly
more difficult problem.
Milton Friedman, a Nobel Prize winning economist, once said that "inflation is always and everywhere
a monetary phenomenon”. This quote reflects the common view of monetarists in their belief
that inflation is tied directly to the supply of money.
They hold both the velocity and output constant.
Therefore, if MV = PY and V and Y are constant, an increase in M will result in an increase
in P.
If we solve for P, then P is equal to MV/Y. If V and Y are held constant, then the value
of P is solely tied to the money supply.
However, not all economic schools of thought accept this idea.
Keynesians argue that the velocity of money and output are NOT constant.
For example, in the recession of 2008, many central banks around the world pursued policies
of quantitative easing that dramatically increased the money supply but did not necessarily translate
into dramatic changes in the price level.
It’s important to note that there is significant debate around this topic and the link between
the money supply and inflation is questioned by many.
Here’s a challenging problem for you to try.
If nominal GDP is $500, real GDP is $250, and the money supply is $50, calculate the
price level and the velocity of money.
Here’s a hint: M = $50 and Y = $250 and MV must equal PY.
Pause the video here and try to solve it on your own. We’ll see how you do after!
If nominal GDP is equal to $500, then we know that MV and PY both equal $500.
Since we know that the money supply is equal to $50, we can solve for the velocity of money.
$50 x V = $500 which means V = $500/$50 or 10.
Similarly, if we know that real GDP is equal to $250, we can solve for the price level.
P * $250 = $500, which means P = $500/$250 = 2.
Therefore $50 x 10 = 2 * $250 or MV = PY.
By now you should have a better understanding about the quantity theory of money and the
Fisher Equation. Also, you should be able to distinguish between the monetarist and
Keynesian view of the quantity theory of money.
This is a complicated topic, so if you had any problems leave your questions or comments
below and let’s try and answer them together. That’s us done for now and I will see you
in the next one!