Quantity Theory of Money

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Inflation prospects in the US and CI

The simplest analytical framework for understanding inflation is the quantity theory of money. This framework may be presented in two different ways.
 
As economists prefer to think of price determination in terms of supply and demand, our preferred formulation of the theory says that the value (purchasing power) of money (‘the price level’ P) results from its supply (M) relative to its demand and that, as the simplest assumption, its demand is proportional (k) to real output (real GDP–q) or M = kqP. An increase in the supply of money (M) will cause prices (P) to rise until the demand for money (kqP) matches the increase in its supply.
 
Thus to a first approximation inflation (which is the rate of change or growth rate of the price level) reflects the growth rate of the money supply or M = q + P, where k is constant, q is independently determined by growth in labour, capital and productivity, and  is the change from one period to the next in whatever it refers to. Hence inflation is determined by the economy’s real economic growth rate and the growth rate of the money supply: P = M – q. This is a simplification of the following P/P = M/M – k/k – q/q, which more correctly reflects the percentage rate of change of each variable. Empirically in most countries the demand for money, k, has also grown modestly over time so that the non-inflationary rate of growth in the money supply has been somewhat higher. If the economy is growing at 3 per cent per year and the money supply is growing at 5 per cent per year, inflation will be approximately 2 per cent per year. However, historical evidence reveals a lag of one to two years between changes in money growth rates and inflation. If money growth increases to say 10 per cent, the impact on inflation would not materialize for another one to two years.
 
Instead of the demand for money formulation described above, the quantity theory of money is sometime presented in term of money’s velocity of circulation (V): MV = Pq. The two versions are equivalent (V = 1/k). The key point is that with a lag of a year or two increases in the rate of growth of the money supply cause a comparable increase in inflation.

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