The Equation of Exchange - YouTube

Hello here we are at beautiful Baja

Tustin at the McNeil International Film

headquarters and today we're going to talk about the equation exchange

and whether it is useful for policy or not.

So the first thing is the equation the exchange is an identity.

It is true by definition. It must be true because it's an identity.

There are four terms:

MV = PQ or PY sometimes.

The money supply

times the velocity a circulation of money is equal to the price level

times the real quality of goods produced in the economy.

Velocity of circulation of money

is the number of times that a

dollar is spent and respent in a year on a final good or service. You can

think of it as the number of trips around the circular flow that a dollar takes in a

year, great The term

Q is real GDP and if you were to take

real GDP, this year's GDP

in real terms and multiply it by the price level you get

nominal GDP. So. PQ

is nominal GDP.

Now, every year

they publish real GDP, the price level,

and they publish the money supply. So

if, for instance, the money supply (and we have to define it as M1 or M2, or even

MZM) but let's say the money supply is 150

and velocity is 4, the price level that is published is 2.0,

that means is that real GDP must be

300 because 150 times 4 must equal

2 times 300.

It's true by definition, it's an

identity. So that's the

equation exchange. The question is whether or not this can be used as a

policy tool

when talking about monetary policy. And so we have to make the first

assumption and that is

if velocity is constan. Velocity is

the inverse of money demand when money demand goes up

velocity of circulation goes down when a

money demand goes down, velocity of circulation goes up.

So if you think of...

if people want to HOLD

less money, for instance during the Weimar Republic in Germany after WWII,

there was horrific hyper-inflation then

when wives would come to the factory gates to collect the money (wages of their spouses).

Workers would be paid two or three times a day and

wives would come to the factory gates and take the money

and then go spend it immediately before it lost its value because

hyper-inflation. Well, in that situation money demand was 0

or as close to zero as they can get so anytime they got money

they immediately spent it. And so, because

it went from hand to hand so rapidly, the velocity of circulation was enormous.

so the point is that when money demand goes down velocity goes up, and

when people are content to hold their money instead of

spending and circulating it, then the velocity of circulation goes down.

They are inverse to each other. OK,

let's change this, MV=PW (money

times its velocity equals price times

real GDP or real quantity) and make it rates of change.

So, the rate of change of the money supply PLUS the

rate of change of velocity

must equal the rate of change of the price level

times the rate of change of real GDP.

Then, let's say if velocity is constant then the

the rate of change of velocity is 0 its constant.

That means that the rate of change

the money supply will show up in nominal GDP.

So that if the money supply grows at four percent per year

nominal GDP must grow at 4 percent per year.

But when it comes to nominal GDP it could be either the price level is growing

four percent and quantity is not changing

or it could be that quantity grows 4 percent and the price level doesn't change.

Or it could be 2 and 2, or some other proportion but the point

is that it

is changing nominal GDP, not necessarily

real GDP. And if you're talking about how monetary policy should be conducted.

the money supply should grow and its effect,

ideally would be on that quantity. You want quantity increases not price level

increases.

So is there a way to figure this out?

We can start looking at this issue.

Is quantity growth (Q)constrained by

real factors? Well when we talk about economic growth,

economic growth is caused by having more resources and better technology,

and improvement in the rules of the game in order to get

real growth (increases in Q). And real growth

in the long run increases in the United States historically at somewhere between

three and four percent.

So if we have money growth of, say 4 percent and quantity of real GDP grows at 4 percent,

then we should expect that the price level will remain constant.

But what if money supply grows at fourteen percent?

Then 4 percent of that increase in the money supply will be

a soaked up by quantity growth and the other 10

must be in price level changes. So

This is Uncle Miltie (Friedman, of course, to you)

Uncle Miltie's monetary rule were basically he assumed

that for policy purposes and over the long run,

velocity was relatively constant, and that you can treat it as a constant for

policy purposes.

If it was your policy goal to have

no growth in prices (i.e., no inflation),

and

if quality is constrained to grow at four percent per year

then what should money supply growth be? The answer is of course is

4 percent. Uncle Miltie's monetary rule is that the money supply should grow at roughly the same

rate as the growth in real GDP in the economy

in order to have non-

inflationary growth and Uncle Miltie said if this is the case

the implication, of course, is that the entire Federal Reserve monetary policy

apparatus - all the people involved and so forth

could be replaced by a well programmed computer. You can imagine how the

people at the Fed

feel about this. Do they agree?

No, there is plenty of evidence to suggest that velocity is not constant.

The question is whether it is constant enough and (for policy purposes)

in the long run it appears

maybe yes constant, or at least for policy purposes whereas in the short run,

velocity bounces around. So that if, for instance the

Federal Reserve to, try and stimulate the economy, increases the money supply by

10 percent, but

if a la city is decreasing

then there's a chance that this increase in the money supply could be

offset by the velocity decreases

and that there can be little or no change on the other side in terms of

nominal GDP.

Conversely when the money supply gets going (increases),

if the price level starts to rise,

money demand starts to go down like it did in the Weimar Republic

and all of a sudden velocity starts increasing tremendously, causing

enormous increases in nominal GDP.

Sadly, the hyperinflation causes price levels to rise very rapidly

but real output just doesn't. Anyway

as a first approximation is always interesting to look at Uncle Miltie's

monetary rule

in terms of their numbers and see how fast the money supply is growing

and then ask if there is a justification for

changing the money supply to be much different from what the

real GDP growth would be.

Anyway, this is the equation of exchange and its usefulness for monetary policy,

Uncle Miltie's monetary rule and the issue of whether

velocity is constant.

That's it. Out.