2. Monetary Theory and Inflation
- Monetary Theory: How changes in the money supply affects the population
- Money Supply: the total amount of cash within a given economy measured by the amount held between firms, households and government.
- Income Velocity: average frequency in which a unit of money is spent in a specific period of time
- GDP: the monetary measure of all the goods and services produced in an economy
- Money Supply (M) x Income Velocity (V) = GDP: The equation that establishes the relationship between these values
- GDP cannot be controlled through
money supply alone. If money supply is increased, but velocity decreases, GDP may stay the same or decline. If money supply is decreased but velocity increases, GDP could increase.
- Price Level and Aggregate Output are also tools that assist in GDP measurement (Q x P = GDP)
-Illustration on measuring GDP through Aggregate Output and Current Price Level
Aggregate Output (Q) x Price Level (P) = GDP
Qcars=10m Pcars=$30k = $300B/Year
Qcars=8m Pcars=$1k = $8B/Year
- The equation of exchange illustrates the relationship between money and price level, and between money and GDP.
M x V = Q x P
- %ΔM + %ΔV = %ΔQ + %ΔP: The equation of exchange transformed to measure rate of inflation.
- %ΔM, %ΔV, and %Δ are the three factors that control inflation therefore the equation can be further simplified as
%ΔP = %ΔM + %ΔV- %ΔQ
- Under the assumption that velocity is constant then the equation again be further simplified as
%ΔP=%ΔM%ΔQ
- Price Index: method that determines the average change in the prices of goods and services between two distinct periods. (Determine the inflation rate)²¹²º
-
Illustration on how price index is used to determine inflation rate.
Pindex²º¹² = Cost of Baskets of Products²º¹²/Cost of Same Basket of Products (Base Year)
Pindex²º¹²= $1.56M/$1M = 1.56
Pindex²º¹¹=$1.5M/$1M = 1.5
Annual Inflation/Deflation Rate= (Pindex²º¹²/ Pindex²º¹¹) = 1.56/1.5= 1.04 (4% Inflation Rate)
- The Price Index can also be utilized as an economic indicator such as a value deflator as a means of adjusting dollar values. Assuming that GDP was valued at $15 Trillion in year 2012, the price index would allow that number to be adjusted for the base year, 2011, which would amount to (15T/1.5) 10 T.
- Real GDP: The value of all goods and services produced in a period that is adjusted for inflation