Quantity theory of money (QTM) – suggests
that the demand for real money balances is
proportional to income.
where M – money supply;
V – velocity of money: the # of
times a PhP bill changes hands for time, t;
P – price level; and,
T – transactions.
Income (Y) version of the QE:
◦ where V: the # of times a PhP bill enters someone’s
◦ P x Y: nominal GDP.
This version of the QTM is used since it is
difficult to observe transactions.
Money Demand & the Quantity Theory of
uses real money balances to measure the
purchasing power of the stock of money;
the money demand function is like the
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GDP deflator (price level) – is the ratio of
nominal to real GDP.
Monetary transmission mechanism :
When BSP ↑MS, since V is fixed, there is a
proportionate ↑nominal GDP;
Since factors of production & the
production fn have already determined
real GDP, the ∆ in nominal GDP must
represent a ∆ in the price level;
Thus, the price level is proportionate to
The QTM is ultimately saying that the BSP,
which controls MS, has control of the
◦ If BSP keeps MS stable, price level will be stable;
◦ If BSP ↑MS rapidly, the price level will ↑ rapidly.
Empirically, there is evidence in the US of
positive correlation between money growth
Q: Why would BSP ↑MS if this is
A: To finance budget deficits.
Governments monetize deficits and
use seigniorage (revenue earned from
↑MS → ↑ inflation → imposes an inflation tax on
holders of money.
As ↑P → ↓Y/P in pocket, making old money in the
hands of public less valuable.
Empirically, countries who rely heavily on
seigniorage have experienced hyperinflation (i.e.
TLP: the demand for real balances depends
on nominal interest rates (i) & Y. The general
money demand function:
◦ Where i : nominal interest rate
Y: level of income
◦ A higher i → a lower (M/P)d
◦ Higher Y → a greater demand for (M/P)d
Fischer equation: shows the relationship between
inflation & interest rate. It has been used to vary
- where r – real interest rate;
π – inflation rate.