Learning Objectives

After you have read this section, friend should have the ability to answer the complying with questions.

You are watching: According to the classical dichotomy, when the money supply doubles which of the following doubles?

What is the quantity theory the money? What is the timeless dichotomy? according to the quantity theory, what determines the inflation rate in the lengthy run?

We start by presenting a structure to highlight the link in between money growth and also inflation over lengthy periods of time.The frame complements our conversation of inflation in the brief run, included in chapter 10 "Understanding the Fed". The quantity theory that moneyA relationship among money, output, and prices the is used to research inflation. Is a relationship among money, output, and prices the is supplied to examine inflation. It is based on an bookkeeping identity that have the right to be traced earlier to the circular flow of income. Among other things, the circular flow tells us that

nominal spending = in the name gross domestic product (GDP).

The “nominal spending” in this expression is carried out using money. If money is composed of plenty of different assets, friend can—as a metaphor—think of money together consisting entirely of dollar bills. In the name spending in the economy would then take the form of this dollar receipt going from human to person. If there room not very many dissension bills loved one to total nominal spending, climate each bill have to be involved in a large number that transactions.

The velocity of moneyNominal GDP divided by the money supply. Is a measure of exactly how rapidly (on average) this dollar bills readjust hands in the economy. It is calculation by dividing nominal spending by the money supply, i beg your pardon is the complete stock of money in the economy:

velocity of money=nominal spendingmoney supply=nominal GDPmoney supply.

If the velocity is high, then because that each dollar, the economy produces a huge amount of in the name GDP.

Using the reality that in the name of GDP amounts to real GDP × the price level, we watch that

velocity of money=price level × real GDPmoney supply.

And if we multiply both sides of this equation through the money supply, we obtain the quantity equationAn equation stating that the it is provided of money times the velocity the money equals nominal GDP., which is one of the most famous expressions in economics:

money it is provided × velocity the money = price level × genuine GDP.

Let us see how these equations job-related by looking in ~ 2005. In that year, nominal GDP was around $13 sunshine in the joined States. The lot of money turn around in the economic climate was around $6.5 trillion.In chapter 9 "Money: A User’s Guide", we debated the reality that over there is no simple single meaning of money. This number refers to a number dubbed “M2,” which includes currency and also deposits in banks that room readily obtainable for spending. If this money took the form of 6.5 sunshine dollar bills changing hands for each transaction that we count in GDP, then, top top average, each bill have to have changed hands twice during the year (13/6.5 = 2). For this reason the velocity the money was 2 in 2005.


Toolkit: section 16.16 "The Circular circulation of Income"

You can review the circular circulation of revenue in the toolkit.


The timeless Dichotomy

So far, we have actually just created a definition. There room two actions that take us from this an interpretation to a concept of inflation. Very first we usage the amount equation to give us a theory of the price level. Climate we study the growth rate the the price level, which is the inflation rate.

In macroeconomics we are constantly careful to distinguish between nominal and also real variables:

Prior to the an excellent Depression, the leading view in business economics was an economic theory called the timeless dichotomyThe dichotomy that real variables are figured out independently of in the name variables.. Back this term sound imposing, the idea is not. According to the timeless dichotomy, genuine variables are figured out independently of in the name variables. In various other words, if you take it the lengthy list the variables used by macroeconomists and also write castle in two columns—real variables top top the left and also nominal variables top top the right—then friend can figure out every the actual variables there is no needing to know any of the in the name variables.

Following the good Depression, financial experts turned instead to the aggregate expenditure modelThe relationship between planned spending and output. To far better understand the fluctuations of the aggregate economy. In the framework, the classical dichotomy does no hold. Financial experts still think the timeless dichotomy is important, however today economists think that the classical dichotomy only applies in the long run.

The classic dichotomy have the right to be viewed from the adhering to thought experiment. Start with a case in i beg your pardon the economy is in equilibrium, an interpretation that supply and also demand are in balance in every the various markets in the economy. The classic dichotomy tells us that this equilibrium identify relative prices (the price of one good in regards to another), not absolute prices. We deserve to understand this an outcome by thinking about the industries for labor, goods, and credit.

Figure 11.2 "Labor industry Equilibrium" gift the labor market equilibrium. ~ above the vertical axis is the real wage since households and firms make their labor supply and also demand decisions based upon real, not nominal, wages. Families want come know how much extr consumption castle can obtain by working more, vice versa, firms want to recognize the price of hiring an ext labor in terms of output. In both cases, it is the genuine wage the determines economic choices.


Figure 11.2 Labor industry Equilibrium

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Now think about the markets for goods and services. The need for any good or service depends on the real earnings of households and also the genuine price that the good or service. We deserve to calculate genuine prices through correcting for inflation: the is, by separating each in the name of price by the accumulation price level. Household need decisions rely on genuine variables, such as real income and relative prices.If you have actually studied the ethics of microeconomics, remember that the budget constraint the a family depends top top income separated by the price the one good and top top the price that one an excellent in terms of another. If there space multiple goods, the spending plan constraint deserve to be established by separating income by the price level and also by dividing all prices by the exact same price level. The exact same is true because that the supply decisions the firms. We have already argued that labor need depends on just the genuine wage. For this reason the it is provided of output additionally depends on the real, not the nominal, wage. More generally, if the firm uses other inputs in the production process, what matters to the that company decision is the price of these inputs loved one to the price of its output, or—more generally—relative to the all at once price level.If you have actually studied the principles of microeconomics, the condition that price amounts to marginal price is provided to characterize the calculation decision of a firm. What matters then is the price that the input, loved one to the price of output.

What about credit markets? The supply and demand because that credit counts on the real interest rate. This way that those supplying credit think around the return they obtain on making loan in genuine terms: back the loan may be stated in terms of money, the supply of credit transaction actually relies on the actual return. The very same is true for borrowers: a loan contract may stipulate a nominal interest rate, but the genuine interest rate determines the expense of borrowing in regards to goods. The it is provided of and demand for credit is portrayed in number 11.3 "Credit sector Equilibrium".


Figure 11.3 Credit sector Equilibrium

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The credit sector equilibrium wake up at a amount of credit prolonged (loans) and also a actual interest rate where the quantity provided is same to the quantity demanded.


Toolkit: section 16.1 "The labor Market", section 16.4 "The credit transaction (Loan) industry (Macro)", and also Section 16.5 "Correcting because that Inflation"

You have the right to review the job market and also the credit market, in addition to the underlying demand and supply curves, in the toolkit. You can additionally review just how to correct because that inflation.


The classical dichotomy has actually a crucial implication the we can study with a comparative statics exercise. Recall that in a compare statics practice we examine just how the equilibrium prices and also output adjust when miscellaneous else, exterior of the market, changes. Right here we ask: what happens to genuine GDP and also the long-run price level as soon as the money supply changes? To find the answer, we start with the quantity equation:

money it is provided × velocity the money = price level × real GDP.

Previously we debated this equation together an identity—something that must be true by the definition of the variables. Currently we revolve it right into a theory. To execute so, we make the assumption that the velocity of money is fixed. This means that any kind of increase in the money supply must boost the left-hand side of the amount equation. Once the left-hand side of the quantity equation increases, then, for any kind of given level of output, the price level is higher (equivalently, for any given worth of the price level, the level of genuine GDP is higher).

What then changes when we adjust the money supply: output, prices, or both? based upon the timeless dichotomy, we know the answer. Genuine variables, together as genuine GDP and the velocity of money, stay constant. A readjust in a nominal variable—the money supply—leads to changes in other nominal variables, however real variables carry out not change. The fact that alters in the money supply have no long-run impact on real variables is referred to as the long-run neutrality that moneyThe truth that changes in the money supply have actually no long-run effect on genuine variables..


Toolkit: section 16.8 "Comparative Statics"

You can find more details on just how to command comparative revolution exercises in the toolkit.


How walk this check out of the effects of financial policy fit through the monetary transmission mechanismA mechanism explaining exactly how the action of a central bank impact aggregate economic variables, in details real GDP.?See chapter 10 "Understanding the Fed". The financial transmission mechanism defines that the financial authority affects aggregate spending by transforming its target interest rate.

The financial authority alters interest rates. Transforms in attention rates affect spending on durables by firms and also households. Transforms in security influence aggregate spending through a multiplier effect.

Remember the the monetary authority alters interest prices through open-market operations. If it desires to boost aggregate spending, that does for this reason by cutting attention rates, and also it cut interest rates by purchasing federal government bonds v money. An attention rate reduced is equivalent to rise in the supply of money, therefore the financial transmission mechanism likewise teaches us that rise in the it is provided of money leader to boost in accumulation spending.There is one difference, unimportant here, i beg your pardon is the the financial transmission system does not necessarily mean that the velocity of money is constant. The monetary transmission mechanism is advantageous when we want to understand the short-run impacts of monetary policy. Once studying the long run, the is simpler to occupational with the amount equation and also to think around monetary policy in regards to the supply of money rather than attention rates.

Finally, a reminder: in the brief run, the neutrality of money does not hold. This is due to the fact that in the brief run we assume stickiness of nominal incomes and/or prices. In this case, alters in the in the name of money supply will lead to transforms in the genuine money supply. Through sticky incomes and/or prices, the timeless dichotomy is broken.


Long-Run Inflation

We currently use the quantity equation to provide us v a concept of long-run inflation. To execute so, we usage the rule of growth rates. One of these rule is as follows: if you have two variables, x and y, then the growth rate of the product (x × y) is the amount of the growth rate of x and the development rate the y. Us can use this come the quantity equation:

money it is provided × velocity the money = price level × genuine GDP.

The left side of this equation is the product of two variables, the money supply and also the velocity that money. The right side is likewise the product of two variables. So us obtain

expansion rate the the money it is provided + growth rate of the velocity that money = inflation rate + expansion rate that output.

We have used the reality that the expansion rate of the price level is, through definition, the inflation rate.


We continue to assume that the velocity the money is a constant.In fact, the velocity of money might likewise grow over time as a result of breakthroughs in the gaue won sector. Saying that the velocity the money is consistent is the same as saying that its development rate is zero. Making use of this fact and also rearranging the equation, we find that the long-run inflation price depends on the difference in between how promptly the money it is provided grows and how promptly output grows:

inflation price = growth rate that money it is provided − growth rate that output.

The long-run expansion rate of calculation does not rely on the development rate of the money supply or the inflation rate. We recognize this due to the fact that long-run output expansion depends ~ above the accumulation of capital, labor, and technology. Indigenous our conversation of labor and credit markets, equilibrium in these markets is defined by real variables. Equilibrium in the labor industry depends ~ above the actual wage and not on any kind of nominal variables. Likewise, equilibrium in the credit sector tells us that the level of invest does not depend on nominal variables. Due to the fact that the resources stock in any period is simply the buildup of previous investment, we understand that the stock of resources is additionally independent of in the name variables.

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Therefore there is a straight link between the money supply growth rate and the inflation rate. The classic dichotomy teaches united state that alters in the money supply carry out not affect the velocity the money or the level that output. It adheres to that any type of changes in the growth rate that the money it is provided will show up one-for-one as alters in the inflation rate. Us say an ext about monetary policy later, but notification that there are immediate implications because that the command of financial policy:

In a farming economy, there are an ext transactions taking place, so there is typically a need for much more money come facilitate those transactions. For this reason some development of the money supply is probably desirable to complement the boosted income. If the financial authorities want a stable price level—zero inflation—in the long run, climate they should try to collection the growth rate of the money supply same to the (long-run) expansion rate that output. If the financial authorities want a low level the inflation in the lengthy run, then they need to aim to have actually the money supply prosper just a tiny bit faster than the development rate the output.

Keep in mind that this is simply a theory. The amount equation holds as an identity. However the assumption of continuous velocity and the statement that long-run output development is live independence of money expansion are assertions based on a human body of theory. We now look at exactly how well this concept fits the facts.


Key Takeaways

The quantity theory that money says that the it is provided of money times the velocity the money equates to nominal GDP. Follow to the classical dichotomy, actual variables, such as genuine GDP, consumption, investment, the genuine wage, and also the real interest rate, are figured out independently of in the name of variables, such together the money supply. Using the amount equation along with the classical dichotomy, in the long run the inflation rate amounts to the rate of money development minus the growth rate that output.

Checking your Understanding

Is the genuine wage a in the name of variable? What around the money supply? If velocity the money reduce by 2 percent and also the money supply does no grow, have the right to you speak what will take place to in the name GDP growth? have the right to you say what will take place to inflation?