[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

Since we are interested in the demand for money, we can rearrange the quantity
equation to express it as
money demand = PY/V.
Money demand changes in proportion to changes in nominal income. An increase in
velocity reduces the demand for money at each level of nominal income. 1
MONEY SUPPLY
The supply of money is affected by government policies. In particular, governments
influence the amount of money in circulation through monetary policy. In the United
States, monetary policy is conducted by the Federal Reserve, commonly called “the
Fed.” How the Fed conducts policy and how monetary policy affects the economy
will be discussed later in this volume (in Chapters 31, 32, and 33). For now, we will
simply assume the government determines the supply of money. Our focus will be
on understanding the consequences for the economy if the government changes
that supply.
THE PRICE LEVEL
We now have the information we need to explain how the price level is determined
when the economy is at full employment. The supply of money is set by the government.
The demand for money depends on the dollar value of transactions in the
economy. The supply of money and the demand for money must be equal when the
economy is in equilibrium. If the supply of money increases, so that at the initial
value of GDP the supply of money is greater than the demand for money, GDP must
rise to restore the balance between money demand and money supply.
GDP can adjust through changes in either the price level or real GDP (or both).
In a full-employment equilibrium, however, real GDP is determined by the level of
employment consistent with equilibrium in the labor market and with the aggregate
production function that determines how much the economy produces when
employment is at that level. At full employment, GDP is equal to PY f , where Y f is
full-employment real GDP. We can then write the requirement that the demand for
money equal the supply of money as
money demand = PY f /V = M = money supply.
For a given level of velocity, it is the price level P that adjusts to ensure that the
demand for money is equal to the supply of money.
1 The inverse of velocity, 1/V, also has its own name—the Cambridge constant—after the formulation of money
demand used by economists (including John Maynard Keynes) at Cambridge University in the early twentieth
century, and it is usually denoted by k. We can then write the demand for money as kPY. The Cambridge constant
is equal to the fraction of nominal income held as money.
PRICES AND INFLATION ∂ 609