Transcript The Monetary Equation of Exchange

THE MONETARY EQUATION
OF EXCHANGE
AP Macroeconomics
MV = PQ
MV


M = SUPPLY OF
MONEY (M1)
V = THE NUMBER OF
TIMES PER YEAR THE
AVERAGE DOLLAR IS
SPENT ON FINAL
GOODS AND SERVICES
PQ


P = THE PRICE LEVEL OR
THE AVERAGE PRICE AT
WHICH EACH UNIT OF
PHYSICAL OUTPUT IS
SOLD
Q = THE PHYSICAL
VOLUME (QUANTITY)
OF ALL GOODS AND
SERVICES PRODUCED,
AKA REAL OUTPUT
MV = PQ
MV

Represents the total amount
SPENT by purchasers of
output
PQ

Represents the total amount
RECEIVED by sellers of that
output
Discussion on Velocity
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Velocity (V) is highly predictable with its value
remaining in a very narrow range over a multi-year
period.
It gradually increases, it is stable!
Why?
Shorter pay periods, greater use of credit cards,
ATM/debit machines
Thus, changes in money supply (M) result in changes
in nominal GDP (PxQ)!
Depending on state of the economy, the changes in the
money supply can result in changes in prices, changes in
output, or some combination of the two.
Activity 36 – Question 1
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M = Money supply (M1)
V = Velocity (The # of times per year the average
dollar is spent on final goods/services)
P = Price level (The average price at which each
unit of physical output is sold)
Q = Quantity (Real output)
Activity 36
2. The product of velocity (V) and the money supply (M) equals
PQ. How can PQ be defined?
Answer: Nominal GDP.
3. Suppose velocity remains constant, while the money supply
increases. Explain how this would affect nominal GDP.
Answer: Nominal GDP (PQ) would increase.
What if the economy is not at full employment?
Answer: both P and Q would increase
What if the economy is at full employment?
Answer: P would increase, but not Q (inflation)
Activity 36
4. During the past 30 years, the use of credit cards has increased, and
banks and financial institutions increasingly use computers for
transactions. Explain how these changes might affect velocity.
Answer: V would increase. A given stock of M could “work harder”
and finance more transactions more quickly.
5. As the result of legislative and regulatory reform throughout the
1980s and 1990s, banks and other financial institutions began
paying interest on a significant proportion of the checkable deposits
in the M1 definition of money supply. Explain how these changes
might be expected to affect the velocity of M1?
Answer: V would decrease. People would be more willing to hold (not
spend) M if it paid interest.