The process through which money creation leads to a higher level of prices. Suppose again that the money supply curve shifts, reflecting an increase in the money supply. * If 1/P does not change, there is an excess supply of money. In other words, people find themselves with more money than they need. * Some people will use the extra money to buy more goods and services. This causes the money price of goods P to increase, and the goods price of money 1/P to fall. * Other people will deposit the extra money in the bank. But then the bank will lend the money to a borrower who wants to buy more goods and services. Again, P will rise and a/P will fall. * This process will continue until monetary equilibrium is restored at a higher price level.
The Classical Dichotomy and Monetary Neutrality
David Hume and his contemporaries suggested that economic variable be divided into two groups. 1. Nominal variables that are measured in units of money (monetary units) 2. Real variables that are measure in units of goods (physical units.) * According to Hume and others, real economic variables do not change with changes in the money supply.
* According to the classical dichotomy, different forces influence real and nominal variables. Changes in the money supply affect nominal variables but not real variables. * The irrelevance of monetary changes for real variables is called monetary neutrality. * This theoretical separation of nominal and real variables is called classical dichotomy.
Velocity and the Quantity Equation
Velocity of money is the rate at which money changes hands, as measured by the number of times each dollar in the economy gets spent during a year.
V = (P * Y)/Mwhere : V = velocity
P = the price level
Y = the quantity of output
M = the quantity of money
Rewriting the equation gives the...