Monetarist Theory states the quantity of money determines the value of money (price level) – i.e. the primary cause of inflation is the growth of money supply
• Implication: In the long run, ↑ MS has no effect on real GDP – ↑ MS only raises price level
“Inflation is always and everywhere a monetary phenomenon”
Milton Friedman The Leading Monetarist Economist Greater GDP
Potential GDP
E
Monetarists believe printing D money does NOT change
Actual and Actual full potential GDP Potential GDP GDP Potential Actual GDP
It only creates inflation! A C B
Time Monetarists do NOT support active monetary policy to adjust business cycle Velocity of Money Explained in 90 Seconds
• The velocity of money is the number of times the average dollar bill is spent in a year – it has been relatively stable since 1960 – Monetarist economists assume velocity is stable
$19.0 Trillion • Velocity = Nominal GDP = 5.2 times Money Supply (M1) $3.6 Trillion (M1)
• Determinants of velocity: – Efficiency of the payments system • Efficiency ↑ = Hold less money = Velocity ↑ Equation of Exchange
Explained in 3 Minutes by MRU Explained by Mr. Clifford in 90 seconds MV = PY Equation of Exchange (Equation of Exchange) Velocity is held constant where: V = Velocity PY = Nominal GDP P = Price level Y = Real GDP M = Money Supply Equation of Exchange Example Assume only product in an economy that can be bought or sold is Pizza. Assume there is $50 in the Money Supply, Pizzas cost $10 and the maximum number of pizzas than can be produced is 100. What is the velocity of money in this economy? What would happen to the real GDP if the Money Supply doubled?
• MV = PY M = $50 V = ? P = $10 Y = 100 pizzas
• Calculate Velocity: – Velocity = 20 [ $50 X ___ = $10 X 100 ] – Nominal GDP = $1,000 – Real GDP = 100 pizzas
• If ↑ M doubled to $50 => $100: – price level (of pizza) would rise $10 => $20 – Nominal GDP ↑ $2,000 – Real GDP unchanged (PPF still = 100 pizzas!) Monetarist Economists Believe Money Supply is NEUTRAL in Long Run
An increase in MS only raises price level (inflation)
MV = PY
Example: If M ↑ 20% then what happens to
• Velocity Held constant (V held constant) • Price Level (P) ↑ 20% • Real GDP (Y) Unchanged ($ neutral) • Nominal GDP (PY) ↑ 20% Monetarist Summary
• Monetarists believe MONEY IS NEUTRAL so MS has no effect on Real GDP More money does not increase the “full potential” of an economy to produce goods/services
• Monetarists believe if the Fed ↑ MS, it causes a proportionate change only in Nominal GDP (P Y) and no change in Real GDP
Monetarist Economist Believe: MV = PY No shift of PPF when MS↑ Qty Food (0,100) . C B . (50,50) . A
(100, 0) Qty Shelter Relationship Between Inflation & Interest Rates Money Market Graph
Fisher Effect Explained in 2 Minutes
Reviewing the Relationship Between Money Market Graph & Loanable Funds Graph in 8 Minutes