(1Growth ofRRealOOutput Suppose the money supply increased by 4%.In a simplified model,this would lead to an increase in Aggregate Demand (AD)of 4%.If AS (productive capacity)stayed static there would be no increase in Real Output,only inflation. However,if the increase in AD of 4%was matched by an increase in AS of 4%,there would be no inflation,but,just an increase in real output. In other words the money supply can grow at the same rate as real output to maintain same price level
Suppose the money supply increased by 4%. In a simplified model, this would lead to an increase in Aggregate Demand (AD) of 4%. If AS (productive capacity) stayed static there would be no increase in Real Output, only inflation. However, if the increase in AD of 4% was matched by an increase in AS of 4%, there would be no inflation, but, just an increase in real output. In other words the money supply can grow at the same rate as real output to maintain same price level. (1)Growth of Real Output
However,if ceter is paribus,money supply grows faster than the rate of real output, it will cause inflation. But,in the real world there are other reasons why an increase in the money supply does not lead to an increase in inflation
However, if ceteris paribus, money supply grows faster than the rate of real output, it will cause inflation. But, in the real world there are other reasons why an increase in the money supply does not lead to an increase in inflation
(2)Hard to Measure Money Supply. Sometimes the money supply is hard to calculate and is constantly changing.Large increases in the money supply are often just due to changes in the way people hold money,such as increase in credit card use may cause an increase in Broad money supply. M1:coins,banknotes and demand deposit M2:Ml+term deposit M3:M2+liquidity assets
Sometimes the money supply is hard to calculate and is constantly changing. Large increases in the money supply are often just due to changes in the way people hold money, such as increase in credit card use may cause an increase in Broad money supply. M1:coins,banknotes and demand deposit M2: M1+term deposit M3: M2+liquidity assets (2)Hard to Measure Money Supply
(3)Velocity of Circulation MV=PY V (velocity of circulation) The quantity theory of money equation assumes that an increase in M causes an increase in P.However,this assumes that V is constant and Y is constant. However,in practices it is not as simple as this equation assumes.In practice there are variations in velocity of circulation
MV=PY V (velocity of circulation) The quantity theory of money equation assumes that an increase in M causes an increase in P. However, this assumes that V is constant and Y is constant. However, in practices it is not as simple as this equation assumes. In practice there are variations in velocity of circulation . (3)Velocity of Circulation
(4)Keynesianvview-LLiquidity Trap In a recession,there may be much spare capacity in the economy.Therefore,an increase in the money supply,merely helps to get unemployed resources used in the general economy.Therefore,in the case of a recession,increased money supply is unl ikely to cause inflation
In a recession, there may be much spare capacity in the economy. Therefore, an increase in the money supply, merely helps to get unemployed resources used in the general economy. Therefore, in the case of a recession, increased money supply is unlikely to cause inflation. (4)Keynesian view – Liquidity Trap