CHAPTER 4 (MANKIW)
THE QUANTITY EQUATION OF MONEY
NOTES by: Chadia Mathurin
THE QUANTITY EQUATION
The Quantity Equation states that M xV = P x T where:
M: is the money supply
V: the velocity of money
P: the prices of goods and services
T: the number of transactions made in the economy.
Making this equation applicable to the macroeconomy, T becomes Y where PY = nominal GDP.
Rearranging the Quantity Equation with V as the subject, we get V= PY/M
THE MONEY DEMAND FUNCTION
The quantity of money in an economy can expressed in terms of the number of goods and services that it can buy. This is called real money balances M/P. Thus real balances is the amount of money in an economy expressed in terms of the number of goods and services that it can buy.
The concept of real money balances can be used to construct a Money Demand Function on the basis that people demand money for the purpose of transactions.
(M/P)d = kY where:
k is a constant denoting how much people want to hold for every dollar of income earned.
Ultimately the money demand function gives a new way to explain the quantity equation. Equilibrating money supply and money demand, gives the Quantity Equation in a rearranged form.
(M/P)d = kY can be rewritten as M x (1/k) = P x Y where:
1/k = V
THE ASSUMPTION OF CONSTANT VELOCITY
The Assumption of Constant Velocity makes the quantity equation a theory of the effects of money supply on the economy, now renamed the Quantity Theory of Money. Constant velocity means that a change in the quantity of money results in proportionate changes in PY (nominal GDP). Thus the Quantity of Money determines the money value of the economy’s output.
THE THEORY OF PRICE LEVELS
The theory of price levels are based on the following assumptions: The factors of production and the production function determine the level of output, Y. The Money Supply M determines the nominal GDP, PY
The velocity of money...