8.2 Fractional Reserve Banking

Upon completion of this chapter you should
understand the quantity theory of money;
know what is meant by velocity; and
understand the rationale behind the monetarist rule.

9.1
The Quantity Theory
In the classical school of thought, supplanted eventually by Keynesianism, a prominent role was played by the quantity theory of money, represented by the mechanical formula
Mv = PQ
Here, P is the overall price level, and Q is the physical quantity of output produced, so that the right-hand side of this formula is the money value of output, or, equivalently, nominal GDP. The variable M is the money supply, and v is the velocity of money, interpreted as the number of times in a year each dollar of money supply is used to buy a final good or service. This is usually expressed as the number of times the money supply "turns over" in supporting financially the production of output.
According to this formula, if velocity is constant, a rise in M causes a rise in either P or Q, depending on whether or not the economy is at full employment. This result is easily seen from looking at the formula Mv = PQ. Clearly, the role of money is center stage in determining the level of economic activity. What is not so easily seen is what is going on in the economy to cause this result to hold, the greatest drawback of the quantity theory: it offers no explanation of how an increase in the money supply causes an increase in economic activity. The quantity theory formula seems to appear as gospel without any theoretical justification. Indeed, velocity is defined as the ratio of income to the money supply, making the quantity theory formula a mere tautology. (Take the equation and solve it for v, obtaining v = PQ/M. If this is how v is defined, then the quantity equation becomes true by definition a tautology!)
The monetarists reinterpreted the quantity theory as representing an economy's demand for money, and with this reinterpretation they were able to structure an explanation for how an increase in the money supply caused an increase in economic activity. The result is referred to as the modern quantity theory of money, and it is a cornerstone of monetarism.
9.2
The Modern Quantity Theory
The original quantity theory formula is rewritten as M = (1/v)PQ and is interpreted as a behavioral equation that reflects the economy's demand for money as nominal income PQ

 



Macroeconomic Essentials. Understanding Economics in the News 2000
Macroeconomic Essentials - 2nd Edition: Understanding Economics in the News
ISBN: 0262611503
EAN: 2147483647
Year: 2004
Pages: 152

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