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Feb 02, 2000 expected inflation. The real money supply is equal to the nominal amount of M1, denoted M0, divided by the fixed aggregate price level, P0. It is assumed that the Fed does not alter the money supply based on the valued of the real interest rate. Therefore, the real money supply function is a vertical line in the graph. In Keynes’ equation, P refers only to the price level of consumption standard value of money, in a narrow sense. In other words, P does not measure the purchasing power of money in a general sense. The real balance equation disregards industrial and financial transactions; hence its application is limited.

11.1 The Quantity Theory of Money

Learning Objectives

After you have read this section, you should be able to answer the following questions.

What is the quantity theory of money?
What is the classical dichotomy?
According to the quantity theory, what determines the inflation rate in the long run?

We begin by presenting a framework to highlight the link between money growth and inflation over long periods of time.The framework complements our discussion of inflation in the short run, contained in Chapter 10 'Understanding the Fed'. The quantity theory of moneyA relationship among money, output, and prices that is used to study inflation. is a relationship among money, output, and prices that is used to study inflation. It is based on an accounting identity that can be traced back to the circular flow of income. Among other things, the circular flow tells us that

nominal spending = nominal gross domestic product (GDP).

The “nominal spending” in this expression is carried out using money. While money consists of many different assets, you can—as a metaphor—think of money as consisting entirely of dollar bills. Nominal spending in the economy would then take the form of these dollar bills going from person to person. If there are not very many dollar bills relative to total nominal spending, then each bill must be involved in a large number of transactions.

The velocity of moneyNominal GDP divided by the money supply. is a measure of how rapidly (on average) these dollar bills change hands in the economy. It is calculated by dividing nominal spending by the money supply, which is the total stock of money in the economy:

velocity of money = \frac{nominal spending}{money supply} = \frac{nominal GDP}{money supply} .

If the velocity is high, then for each dollar, the economy produces a large amount of nominal GDP.

Using the fact that nominal GDP equals real GDP × the price level, we see that

velocity of money = \frac{price level × real GDP}{money supply} .

And if we multiply both sides of this equation by the money supply, we get the quantity equationAn equation stating that the supply of money times the velocity of money equals nominal GDP., which is one of the most famous expressions in economics:

money supply × velocity of money = price level × real GDP.

Let us see how these equations work by looking at 2005. In that year, nominal GDP was about $13 trillion in the United States. The amount of money circulating in the economy was about $6.5 trillion.In Chapter 9 'Money: A User’s Guide', we discussed the fact that there is no simple single definition of money. This figure refers to a number called “M2,” which includes currency and also deposits in banks that are readily accessible for spending. If this money took the form of 6.5 trillion dollar bills changing hands for each transaction that we count in GDP, then, on average, each bill must have changed hands twice during the year (13/6.5 = 2). So the velocity of money was 2 in 2005.

Toolkit: Section 16.16 'The Circular Flow of Income'

You can review the circular flow of income in the toolkit.

The Classical Dichotomy

So far, we have just written a definition. There are two steps that take us from this definition to a theory of inflation. First we use the quantity equation to give us a theory of the price level. Then we examine the growth rate of the price level, which is the inflation rate.

In macroeconomics we are always careful to distinguish between nominal and real variables:

Nominal variablesA variable defined and measured in terms of money. are defined and measured in terms of money. Examples include nominal GDP, the nominal wage, the dollar price of a carton of milk, the price level, and so forth. (Most nominal variables are measured in monetary units, but some are just numbers. For example, the nominal interest rate tells you how many dollars you will obtain next year for each dollar you invest in an asset this year. It is thus measured as “dollars per dollar,” so it is a number.)
All variables not defined or measured in terms of money are real variablesA variable defined and measured in terms other than money, often in terms of real GDP.. They include all the variables that we divide by a price index in order to correct for the effects of inflation, such as real GDP, real consumption, the capital stock, the real wage, and so forth. For the sake of intuition, you can think of these variables as being measured in terms of units of (base year) GDP (so when we talk about real consumption, for example, you can think about the actual consumption of a bundle of goods and services by a household). Real variables also include the supply of labor (measured in hours) and many variables that have no specific units but are just numbers, such as the velocity of money or the capital-to-output ratio of an economy.

Prior to the Great Depression, the dominant view in economics was an economic theory called the classical dichotomyThe dichotomy that real variables are determined independently of nominal variables.. Although this term sounds imposing, the idea is not. According to the classical dichotomy, real variables are determined independently of nominal variables. In other words, if you take the long list of variables used by macroeconomists and write them in two columns—real variables on the left and nominal variables on the right—then you can figure out all the real variables without needing to know any of the nominal variables.

Following the Great Depression, economists turned instead to the aggregate expenditure modelThe relationship between planned spending and output. to better understand the fluctuations of the aggregate economy. In that framework, the classical dichotomy does not hold. Economists still believe the classical dichotomy is important, but today economists think that the classical dichotomy only applies in the long run.

The classical dichotomy can be seen from the following thought experiment. Start with a situation in which the economy is in equilibrium, meaning that supply and demand are in balance in all the different markets in the economy. The classical dichotomy tells us that this equilibrium determines relative prices (the price of one good in terms of another), not absolute prices. We can understand this result by thinking about the markets for labor, goods, and credit.

Figure 11.2 'Labor Market Equilibrium' presents the labor market equilibrium. On the vertical axis is the real wage because households and firms make their labor supply and demand decisions based on real, not nominal, wages. Households want to know how much additional consumption they can get by working more, whereas firms want to know the cost of hiring more labor in terms of output. In both cases, it is the real wage that determines economic choices.

Now think about the markets for goods and services. The demand for any good or service depends on the real income o

Quantity Equation Real Money Balances