Unit 5: Long-Run
Consequences of Stabilization
Policies
Topic 5.3 –
Money Growth and Inflation
Quantity Theory of Money
If a train can carry a maximum of 200 passengers, how
can it transport 1,200 passengers a day?
If real GDP is $400 billion but the amount of money in the
economy is only $100 billion, how are these transactions taking
place?
The velocity of money is the average times a dollar is spent and
re-spent in a year.
What is the velocity of money in the above example?
Quantity
M Theory
x V = P xof
Y Money
M = money supply P = price level
V = velocity Y = quantity of
output
Notice that P x Y = Nominal GDP
Assume that velocity is relatively constant because people's spending habits are not quick
to change and that output (Y) is not affected by the quantity of money because it is based
on production, not the value of the stuff produced.
If the government increases the amount of money (M), what
will happen to prices (P)?
Ex: Assume money supply is $5 and it is being used to buy 10 products with a price of
$2 each.
1. How much is the velocity of money?
2. If the velocity and output stay the same, what will happen if the amount of money
is increased to $10?
Equilibrium Price Level & Inflation Rate
• The velocity of money is relatively stable over time
• Because velocity is stable, when the central bank changes the
quantity of money (M), it causes proportionate changes in the nominal
value of output (P x Y)
• The economy’s output of goods and services (Y) is primarily
determined by factor supplies (land, labor, capital, etc.) & available
technology
• When the central bank alters the money supply (M) & causes
proportional changes in the nominal value of input (P X Y), these
changes are reflected in changes in the price level (P)
• Therefore, when the central bank increases the money supply
rapidly, the result is high inflation
Money and Inflation
What happens in the long-run when the central bank
increases in the money supply?
• Short-run spending eventually leads to higher
resource prices and inflation.
• If inflation is bad enough, banks don’t lend and
the economy tanks.
Question: If this is true, why do many economists
support expansionary monetary policy?
Answer: Monetary policy can increase real output in
the short-run.
Demand-Pull Inflation
The demand for consumer goods outpaces
the ability to supply
Demand-Pull Inflation
Five Causes
1. A Growing Economy – When consumers feel confident, they spend more
and take on more debt
– Leads to a steady increase in demand = higher prices
2. Increasing Export Demand – A sudden rise in exports forces an
undervaluation of the currencies
3. Government Spending – When the government spends more freely,
prices go up
4. Inflation Expectations – Companies may increase their prices in
expectation of inflation in the near future
5. More Money in the System – An expansion of the money supply with too
few goods to buy makes prices increase
Cost Push Inflation
The cost to produce goods and services
outpaces the demand of those goods and
services
Cost Push Inflation
• Prices increase due to an increase in resource prices or
inputs (wages, raw materials, inputs)
• Causes a decrease in aggregate supply
• Since demand hasn’t changed, price increases from
production are passed on to consumers
• Examples: a change in minimum wage; a change in oil
prices
