Economic Fluctuations: Unemployment and Inflation Inflation The Quantity Theory of Money Page 1 of 3

We’ve talked about output, we’ve talked about unemployment, and we’ve talked about inflation. Now it’s time to construct a story that begins to fit together all of these variables in the macroeconomy. In this discussion, we’re going to be building what I think is the simplest model in macroeconomics. It’s great though because it shows a simple relationship between money, output, and prices – three of the most important variables in describing the macroeconomy.

The model is called the quantity theory of money, and it begins with a very simple insight. That is, all the shopping that people are doing in our economy has to be paid for somehow. Anytime you’re doing shopping, you are either handing someone cash or writing a check. Even if you’re paying with a credit card, you’re eventually settling that account with cash or a check. So the shopping that’s done in the economy depends critically on the amount of money there is available to make that shopping happen. This is the insight behind the quantity theory of money.

Let me build an equation that shows the quantity theory’s story. Let’s start with the gross domestic product of the economy. The gross domestic product has two components – the prices people pay for the output, real goods and services that they guy. If you multiply prices times quantity, and add them up, you get the total shopping bill for the economy, the real gross domestic product – the market price of all final goods and services that are produced in the economy in a year.

Now, how do people pay for this stuff? Whenever they go and they buy these goods and services, what are they using to settle the transaction? They’re using money, and by money, we mean currency and checks. These are what are called transactions instruments, or the payment system. If we take all the cash and checks that are out there in the economy, then we’ve got the money supply. The money supply is what people use for shopping. If you want to know whether something’s money or not, answer this question: Could you use it to pay the pizza delivery guy when he brings your pizza? Checks, yes; cash, yes; definitely not bonds; certainly not shares of stock. I mean, that other stuff isn’t money, but all cash and currency is.

Then, there’s this other matter of velocity; that is, in the United States right now, the gross domestic product is close to $13 trillion. The money supply, however, is only $1.4 trillion. What does that tell you? It tells you that there’s about nine times as much value in shopping being done as there is money to make that shopping possible. That means that the money has to be circulating in the economy. A given dollar bill is spent again and again and again, on average nine times a year. That nine times is what we call the velocity of money. The velocity of money is defined as the average number of times that a dollar bill in our economy is spent and re-spent in the course of a year.

So this equation that I’ve written down, which is sometimes called the quantity equation, is really just a matter of accounting. All the shopping that’s done in the economy has to be paid for with money. And since there’s a limited stock of money, a given dollar bill is spent again and again in the course of a year. In the U.S. economy, $9 trillion worth of shopping, $1.4 trillion worth of money – a given dollar bill spent again and again, nine times.

Now, to turn this into a theory about the way the economy works, let’s make an assumption about velocity. Let’s suppose that people spend and re-spend money at a constant rate. That’s not exactly realistic. When interest rates are high, people want to get by with less money, because they want to put more of their wealth in bonds and stocks and mutual funds and savings accounts, and other forms that aren’t money. However, let’s suppose for the sake of simplicity that people spend money at a constant rate – anytime you get money, you typically spend it within a certain amount of time. Well, if that’s true, if the velocity of money is constant – and I’ll hold it constant by putting a bar over the top of it, this red bar means that velocity doesn’t change – if that’s the case, then any change in the money supply has to show up as a change in gross domestic product – which means either a change in the price level, a change in output, or a change in both.

Let me take a very simple numerical example in which the economy produces one product – cars, and that’s our gross domestic product is the amount of money that’s spent in our economy on cars in a year. Suppose there’s $1.00 in the economy, so the money supply is $1.00. And let’s suppose that the velocity of money is 2 – and you’ll see where that

Economic Fluctuations: Unemployment and Inflation Inflation The Quantity Theory of Money Page 2 of 3

comes from in just a moment. Well, if the price of a car is $2.00, and we have one car produced in our economy, then the gross domestic product is $2.00, which means that our dollar bill has to be spent on average two times in a year to pay for this shopping.

Let’s start with those numbers, and let’s ask the question, What would happen in this economy if we increased the money supply? Now, with Gary’s help, we’re going to print a little bit of extra money, and we’re going to find out what happens to the variables we care about, what happens to prices and output when money increases. So Gary, let’s put a little bit of paper in our printing press, and see if we can’t get some money out. Great, thank you very much. So now we’ve doubled our money supply; we’ve gone from $1.00 to $2.00 worth of money. And now that we have $2.00 in the money supply, with a velocity of 2, something’s got to give over here. There are two things that could happen.

Well, one thing that could happen is that the extra money makes credit easier to get. Since we’ve pumped more money into our economy, banks may be more likely to make you a loan, because the money isn’t as scarce as it was before. If credit is easier to get, businesses are likely to expand and produce more output, and real GDP – that is why the output of the economy could increase. That’s possibility number one.

So we have two cars, at $2.00 apiece equals $4.00 of gross domestic product, which is our $2.00 money supply multiplied by the velocity of 2. These $2.00 circulate to create this gross domestic product. So one possibility is an increase in the money supply working through the banking system, through the credit markets, lowered the interest rate, makes credit easier to get, encourages businesses to expand, and gives us a higher real output.

The alternative is that output doesn’t change at all, and the price level simply increases from $2.00 to $4.00. That is, with more money in the economy, people are spending a higher quantity of nominal money on one car, which is going to drive up its price. That is, the price of the car is bid up, there is no more real output, and therefore the increase in the money supply is purely inflationary. All it does is result in an increase in the price level.

So, two possibilities: an increase in the money supply if velocity is constant can either increase real output, or it can increase the price level. At this point, you’ve got a very good question, and that is, How do we know which one is going to happen? How do we know whether an increase in the money supply is going to lead to an expansion in the real economy, or simply create inflation? The answer depends on where we start. That is, when we increase the money supply, are we at a point in the economy where there’s slack, where there are unemployed workers, where there is unemployment among raw materials, where there’s stuff that’s not being used. If we’ve got slack, if we’re in a place of unemployment in the economy, an increase in the money supply is more likely through its effect on the credit markets, to increase real output, and give us this outcome. That is, an increase in the money supply is likely to provoke an expansion in the real economy.

However, again, this depends on the fact that we’d be starting in a recession, or in a period of unemployment. This is what happened in the United States in the early 1990s. We were in a recession, and the Federal Reserve, through its cooperation with the banking systems, increased the money supply, encouraged banks to lend more freely, businesses expanded, and the economy grew, and real output increased.

On the other hand, if we’re already at full employment, and we can’t produce anymore output – that is, if unemployment is low, if raw materials are already fully employed, if we’re right up against the speed limit of the economy, if we’re at the non-accelerating inflationary rate of unemployment –if we’re at that point, then pumping more money in isn’t going to get you any more stuff, because there’s no more stuff to make. We’re right at the capacity of the economy; therefore, the increase in the money supply only increases the price level. This is the case frequently. In fact, the Fed is afraid – the Federal Reserve system is concerned that the U.S. economy might be at that place right now, and that the growth rate of the money supply, if it were to increase, would not give us extra output, but only spark inflation.

Now the classical economists focused on the capacity of the economy. They believe that output was in the long run

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fixed and that it couldn’t increase. Therefore, in the long run, if output can’t increase, then any change in the money supply, in the long run, is purely going to affect prices; there’s going to be no change in output. So a reduction in the money supply is going to lower prices; an increase in the money supply is going to increase prices.

In the classical view of the economy, money doesn’t affect real variables. It affects only nominal variables. That is, the money supply, which is measured in money, a nominal variable, influences prices, the other nominal variable, without any affect on output, the real variable. So in the classical view of the quantity theory of money, velocity is stable, output is fixed, and increases in the money supply affect only the price level. Nominal variables influence only nominal variables.

Now a minute ago Gary came in and printed money for us, and this is what happens in a lot of governments that don’t have alternatives for financing public goods. That is, if the only way you can finance public goods is by printing more money, you’re likely to provoke inflation in your economy. This is called the inflation tax, where people throughout the economy pay for the government’s spending in the form of higher prices for all goods and services, because the government is spending by printing money; and printing money, in the long run, is going to be purely inflationary.

So, see, with this quantity theory of money, we’re able to come up with a simple relationship among some very important macroeconomic variables – money, the price level, and the real economy. We’ll be building some more complicated models as our discussion of macroeconomics progresses, but it’s great to have a simple model to start with, because it does explain a lot.