In the classical model, YD is not determined by P but rather the opposite; P is determined by YD (which is equal to YS) and the money supply (which is included in the constant). Aggregate demand is always equal to the aggregate supply by Say’s Law.

Suppose that nominal GDP is equal to 100 for a particular year while the money supply is constant and equal to 20 throughout that year. To compute real GDP for 2002, we use the prices of hot dogs and hamburgers in 2001 (the base year) and the quantities of hot dogs and hamburgers produced in 2002.

The nominal wage Is equal to the real wage times the price level. Since V is stable (let’s say it too is constant), the percentage change in P is equal to the percentage change in M. That is, inflation is equal to the growth rate of money or n = K„,. xref The real exchange rate is … Recall that nominal GDP can rise for two reasons: an increase in output, and/or an increase in prices. The quantity theory of money connects three important variables: M, P, and Y: the money supply, the price level and the real GDP. In the quantity theory, the velocity of money is an exogenous variable. If we do not remove the trend in Y, the result would instead be that inflation is equal to the growth in money supply minus the growth in real GDP.

The quantity theory of money takes for granted that what ultimately matters to holders of money is the real quantity rather than the nominal quantity they hold and that there is a fairly definite real quantity of money that people wish to hold under any given circumstances. Similarly V is an exogenous variable in agreement with the quantity theory of money. 0000000777 00000 n Note that using this equation provides an approximation for small changes in the levels. 17 0 obj <>stream Since we are using money to buy finished goods, we may conclude that every monetary unit (USD or euro or whatever) has been used an average of 5 times during the year (100/20). If we combine this with the quantity theory of money, we can determine the price level P: P = (M- V)/Y.

0000000456 00000 n Key Concepts and Summary The relationship between the supply of money and inflation, as well as deflation, is an important concept in economics.The quantity theory of money is a concept that can explain this connection, stating that there is a direct relationship between the supply of money in an economy and the price level of products sold. In the classical model, money supply M is an exogenous variable (hence, the growth rate in the money supply nM is exogenous).

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