Lesson 11
MONEY AND INFLATION (CONTINUED)
MONEY SUPPLY MEASURES
SYMBOL ASSETS INCLUDED
C Currency
M1 C + demand deposits, travelers’ checks, other checkable deposits
M2 M1 small time deposits, savings deposits, money market mutual funds,
money market deposit accounts
M3 M2 + large time deposits, repurchase agreements, institutional money
Market mutual fund balances
MONEY DEMAND AND THE QUANTITY EQUATION
Let’s now express the quantity of money in terms of the quantity of goods and services it can
buy.
M/P = Real money balances, the purchasing power of the money supply.
A simple money demand function: (M/P)d = kY
Where, k = how much money people wish to hold for each rupee of income (k is exogenous).
This equation states that the quantity of real money balances demanded is proportional to real
income.
Money demand: (M/P)d = kY
Quantity equation: M uV = P uY
The connection between them: k = 1/ V, when people hold lots of money relative to their
incomes (k is high), money changes hands infrequently (V is low).
THE QUANTITY THEORY OF MONEY IN TERMS OF GROWTH
Recall the growth rate of a product equals the sum of the growth rates.
The quantity equation in growth rates:
The quantity theory of money assumes V is constant, so V/V = 0.
Let S (Greek letter “pi”) denote the inflation rate:
We have,
Solve this result for S to get
Normal economic growth requires a certain amount of money supply growth to facilitate the
growth in transactions. Money growth in excess of this amount leads to inflation. 'Y/Y
depends on growth in the factors of production and on technological progress (all of which we
take as given, for now). Hence, the Quantity Theory of Money predicts a one-for-one relation
between changes in the money growth rate and changes in the inflation rate.
MV PY
MV PY
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P
P
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S
MPY
MPY
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S
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MY
MY
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