38. The Quantity Theory of Money

The quantity theory of money is the proposition that in the long run, an increase in the quantity of money brings an equal percentage increase in the price level.

The velocity of circulation is the average number of times a dollar of money is used annually to buy the goods and services that make up GDP. Nominal GDP equals real GDP, Y, multiplied by the price level, P, or GDP=PY. So the velocity of circulation, V, is given by V = PY/M.

The equation of exchange states that the quantity of money, M, multiplied by the velocity of circulation, V, equals GDP: MV = PY. The equation of exchange is a definition and so is always true. It becomes the quantity theory of money by adding two assumptions:

The velocity of circulation is not influenced by the quantity of money.

Potential GDP is not influenced by the quantity of money.

The equation of exchange can be rearranged as P = M(V/Y). This equation, together with the assumptions about velocity and potential GDP, implies that in the long run, the price level is determined by the quantity of money.

In growth rates, the equation of exchange is: (Money growth rate) + (Growth rate of velocity) = (Inflation rate) + (Real GDP growth rate). Rearranging this equation gives (Inflation rate) = (Money growth rate) + (Growth rate of velocity)  (Real GDP growth rate). If velocity does not grow, then in the long run the inflation rate equals the growth rate of the quantity of money minus the growth rate of potential GDP.

The predictions of the quantity theory can be tested using evidence on money growth and inflation across time. On the average, the money growth rate and the inflation rate are correlated, supporting the quantity theory. The predictions of the quantity theory also can be tested using the evidence on money growth and inflation across countries. As predicted, rapid money growth is correlated with high inflation.

39. The Exchange Rate and the Balance of Payments

International trade, borrowing, and lending, make it necessary to exchange currencies and the foreign exchange value of the dollar is determined in the foreign exchange market.

The exchange rates for currencies are determined by supply and demand in the foreign exchange market.

When a nation trades with other nations, the country’s balance of payments records the transactions.

40. The Foreign Exchange Market

International trade, borrowing, and lending, make it necessary to exchange currencies. Foreign currency is the money of other countries regardless of whether that money is in the form of notes, coins, or bank deposits. The foreign exchange market is the market in which the currency of one country is exchanged for the currency of another. The price at which one currency exchanges for another is called the exchange rate.

Over time, the U.S. dollar appreciates and depreciates against other currencies such as the Japanese yen or European euro. Currency depreciation is the fall in the value of one currency in terms of another currency. Currency appreciation is the rise in the value of one currency in terms of another currency.

A rise in the U.S. exchange rate is called an appreciation of the dollar; a fall in the U.S. exchange rate is called a depreciation of the dollar.

The exchange rate is determined by demand and supply in the (competitive) foreign exchange market. When people holding the money of some other country want to exchange it for U.S. dollars, they supply the other currency and demand dollars. When people holding U.S. dollars want to buy the currency of some other country, they supply U.S. dollars and demand the other currency.