MacroeconomicsI_working_version (1)

72
Chapter 7
A rise in the money supply is the opposite case. People hold more money than they wish,
which results in increased demand for bonds. The excess demand for bonds raises the bond
prices and reduces interest yields. Decreasing interest rate increases demand for money
until the equilibrium is restored. The equilibrium interest rate clears the money market
again.
7.8. The Quantity Theory
The quantity theory of money resulted from the old question of what is the relation among
money, prices and output. Many centuries ago people were interested how the amount of
money influences the total production in a country. The modern result of that interest is the
quantity theory of money expressed by the famous quantity equation.
M × V = P × Y
The quantity equation provides a very simple link among the price level, the level of output
and the money stock. Assumptions that both V 6 (the income velocity of money) and Y (real
output, also labelled as Q) are fixed made this theory the classical quantity theory of
money. In real, the classical assumptions of output remaining at the potential level and
fixed velocity of money do not always hold. In spite of that fact, holding these
assumptions, it is interesting to conclude that the price level is proportional to the supply of
money. Accordingly, the classical version of quantity theory of money was, in fact, the
theory of inflation.
The classical version of quantity theory of money suggests that the price level is
proportional to the money stock:
P
=
V
× M
Y
Assuming constant V, changes in the money supply lead to proportional changes in
nominal GDP, P× Y . Under the classical assumptions, Y is fixed at the potential level.
Thus, changes in the money supply cause the proportional changes in the overall price
level, P.
6 The income velocity of money refers to the number of times the stock of money is turned over per year in
financing the annual flow of income. It is equal to the ratio of nominal GDP to the nominal money stock.
P × Y Y
V = =
M M P