5.3 — Money Growth and Inflation

Inflation and deflation result from an increase or decrease in the money supply at a rapid rate for a sustained period of time. However, when the economy is in full employment, changes in the money supply have no effect on real output in the long run.

Equation of Exchange

There’s a fundamental equation of exchange: $MV=PY$ where:

• $M$ is the money supply (country/economy and how much money)
• $V$ is the velocity of money (number of times each dollar changes hands in a year)
• $P$ is the price level (any price index)
• $Y$ is the real output (sometimes $Q$)

Remember that $PY$ itself represents the nominal GDP.

Long-Run Conclusions

1. In the long run, changes in price level are directly proportional to changes in money supply We can see this because both $M$ and $P$ are proportional in the fundamental equation of exchange. Essentially, if the money supply increases, so will the price level.

2. In the long run, change in money supply has no effect on real variables Since price level is the element changing, we can assert that changes in money supply has no impact on the real output (since price level is the element that is changing).