All Terrain Thinking

A Compendium of things I think are Important

Economics: It's not just whats' in your wallet

Equation of Exchange

MV = PY

• M = money supply
• V = velocity (number of times each dollar is spent in a year)
• P = price level
• Y = real GDP

This equation is simply stating the obvious - that the value of transactions in the economy (PY) is constrained to be equal to the total buying power in the economy (MV). The key to this equation is velocity. If you look in your pocket you will find some dollar bills. A few days ago these dollars were probably in the pocket of someone else who spent them to buy some 'stuff.' The number of times in a year that the dollar is spent is called velocity. This equation is simply stating that if we take the amount of dollars and multiply them by the average number of times each dollar is spent, we have a measure of total spending capacity. If the money supply consists of one hundred $10 bills and each is spent 15 times in a year, the total spending capacity (P*Y) will be equal to 100*10*15= 15000. This is simply an accounting identity.

Dynamic Version of Equation of Exchange-again

m + v = p + y

• m = % change in money supply
• v = % change in velocity
• p = % change in price level
• y = % change in real GDP

To get from the first equation of exchange (MV = PY) to the second ( m + v = p + y) we need only use a little algebra - which we will not do here. This equation specifies the relationships between the growth rates in the variables. The growth rate in the money supply plus the growth rate in velocity equals the growth rate in nominal output which in turn equals the growth rate in the price level plus the growth rate in real output. If we accept the Classical assumptions that the the level of output will be unaffected by changes in the money supply (y = 0) and that velocity will be constant (v=0), then we are left with a direct relationship between the growth rate in prices and the money supply

p = m

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