Chapter 22, Problem 1LO

To determine

The relationship between money growth and inflation in the short-run and long-run, as implied by the quantity theory of money.

Explanation of Solution

Quantity theory of money is called theory of inflation. The equation can be rewritten as

  $\%\Delta M+\%\Delta V=\%\Delta P+\%\Delta Y$

Inflation is $\%\Delta M+\%\Delta V-\%\Delta Y=\%\Delta P=\pi$ ,

As velocity is zero or constant, then,

  $\%\Delta M-\%\Delta Y=\%\Delta P=\pi$

In short-run, there is no correlation between output and money growth, as increase in money growth rate takes time (time lag) to increase the productivity of an economy.

In long-run, there is a strong correlation between output and money growth. As money supply increases, productivity of output in long-run increases. It has been noted that, countries with high money growth usually have high-inflation rates.

So, inflation is always and everywhere a monetary phenomenon is accurate in long-run but not accurate in short-run.

Economics Concept Introduction

Introduction:

Quantity theory of Money explains the relation 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 the aggregate output.

M*V=P*Y.