Quantity Theory of Money

Chahir Zaki

FEPS, Cairo University

Second semester, 2012

Outline

1. Introduction

2. History

3. Velocity

4. Quantity Theory of Money

5. Velocity in Egypt

Outline

1. Introduction

2. History

3. Velocity

4. Quantity Theory of Money

5. Velocity in Egypt

Introduction

• The quantity theory of money is a theory of how the nominal value of aggregate income is determined.

• Because it also tells us how much money is held for a given amount of aggregate income, it is also a theory of the demand for money.

• The most important feature of this theory is that it suggests that interest rates have no effect on the demand for money.

Outline

1. Introduction

2. History

3. Velocity

4. Quantity Theory of Money

5. Velocity in Egypt

History

•The clearest exposition of the classical quantity theory approach is found in the work of the American economist Irving Fisher, in his influential book The Purchasing Power of Money, published in 1911.

•Fisher wanted to examine the link between the total quantity of money M (the money supply) and the total amount of spending on final goods and services produced in the economy P Y, where P is the price level and Y is aggregate output (income or nominal GDP.)

Outline

1. Introduction

2. History

3. Velocity

4. Quantity Theory of Money

5. Velocity in Egypt

Velocity of Money and Equation of Exchange

M= the money supply

P = price level

Y = aggregate output (income)

P Y aggregate nominal income (nominal GDP)

V = velocity of money (average number of times per year that a dollar is spent)

V P Y

M

Equation of Exchange

M V P Y

Velocity of Money

• The concept that provides the link between M and P , Y is called the velocity of money:

• The rate of turnover of money • The average number of times per year that a dollar is spent in buying the total amount of goods and services produced in the economy.

Velocity of Money

• Irving Fisher reasoned that velocity is determined by the institutions in an economy that affect the way individuals conduct transactions.

• If people use charge accounts and credit cards to conduct their transactions and consequently use money less often when making purchases, less money is required to conduct the transactions generated by nominal income (M↓ relative to P Y), and velocity (P Y )/M will increase. • Conversely, if it is more convenient for purchases to be paid for with cash or checks (both of which are money), more money is used to conduct the transactions generated by the same level of nominal income, and velocity will fall.

Outline

1. Introduction

2. History

3. Velocity

4. Quantity Theory of Money

5. Velocity in Egypt

Quantity Theory

• Velocity fairly constant in short run

• Aggregate output at full-employment level

• Changes in money supply affect only the price level

• Movement in the price level results solely from change in the quantity of money

Quantity Theory of Money Demand

Divide both sides by V

M = 1

V PY

When the money market is in equilibrium

M = M d

Let k 1

V

M d k PY

Because k is constant, the level of tranactions generated by a

fixed level of PY determines the quantity of M d

The demand for money is not affected by interest rates

Outline

1. Introduction

2. History

3. Velocity

4. Quantity Theory of Money

5. Velocity in Egypt

Velocity with M2

0

1

2

3

4

5

6

7

8

FY91 FY92 FY93 FY94 FY95 FY96 FY97 FY98 FY99 FY00 FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10

Velocity with M1

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

FY91 FY92 FY93 FY94 FY95 FY96 FY97 FY98 FY99 FY00 FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10

References

• Chapter 19, Mishkin

• Central Bank of Egypt

Thanks for your attention