Inflation: The Quantity theory of money

Question 1

What is the core idea of the quantity theory of money, and how does it relate to the MV = PY?

Answer 1

money is held to facilitate economic activity — the more that needs to be bought or sold, the more money is needed.

Question 2

Why do economists measure total output (nominal GDP) instead of total transactions in the quantity equation?

Answer 2

Because total transactions include all exchanges, even second-hand goods or financial assets, which can be hard to track and don’t reflect current production. Nominal GDP (PY) only includes newly produced goods and services, making it a more accurate and measurable indicator of economic activity.

Question 3

What is the quantity equation in its income-based form?

Answer 3

MV = PY

Question 4

What does M stand for in the quantity equation?

Answer 4

The money supply (total quantity of money in the economy).

Question 5

What does V stand for in the quantity equation?

Answer 5

The income velocity of money — how many times a dollar is used to purchase newly produced goods and services in a year.

Question 6

What does P stand for in the quantity equation?

Answer 6

The price level, often measured by the GDP deflator.

Question 7

What does Y stand for in the quantity equation?

Answer 7

Real GDP — the total quantity of goods and services produced in the economy.

Question 8

What does PY represent in the quantity equation?

Answer 8

Nominal GDP — the total value of output at current prices

Question 9

Why do economists prefer using Y instead of T in the quantity equation?

Answer 9

Because output (Y) is easier to measure than the number of individual transactions (T), which can be hard to track.

Question 10

Are output (Y) and transactions (T) the same thing?

Answer 10

No — transactions include all exchanges (even second-hand goods), but output only includes new production.

They are correlated

Question 11

What is the meaning of the velocity of money?

Answer 11

It measures how many times a unit of currency is used in a year to buy goods and services.

Question 12

How can velocity (V) be calculated from the equation?

Answer 12

V = PY / M

Question 13

If M = 300 and PY = 1200, what is V?

Answer 13

V = 4

Question 14

If V = 3 and M = 400, what is nominal GDP (PY)?

Answer 14

PY = 1200

Question 15

What are “real money balances,” and how are they calculated?

Answer 15

Real money balances are the purchasing power of the money supply, showing how much stuff you can buy .
They’re calculated as:
M/P

where M is the money supply and P is the price level.

Question 16

What are real money balances?

Answer 16

The purchasing power of money, calculated as MPPM​, where M is the money supply and P is the price level.

Question 17

What does the equation
M/P=kY represent?

Answer 17

The money demand function — it shows that people want to hold a constant fraction k of their income (Y) as real money balances.

Question 18

What does the constant k mean in the money demand function?

Answer 18

It tells us how much money people want to hold per dollar of income.

Question 19

Why do people demand money even though it doesn’t earn interest?

Answer 19

Because money is convenient for making transactions, just like a car is convenient for travel.

Answer 20

Rearranging M/P=kY gives M=kPY, which becomes MV=PY since V=1/k

Question 21

What is the formula for velocity in terms of the money demand parameter k?

Answer 21

V= 1/k

Question 22

If k=0.25k and Y = 2000, what are real money balances?

Answer 22

M/P = 0.25×2000=500

Question 23

If MP=400PM​ and Y = 2000, what is k?

Answer 23

k=400/2000=0.2

Question 24

If k=0.2k, what is velocity (V)?

Answer 24

V= 1/0.2 ​=5

Question 25

What is nominal GDP (or nominal output)?

Answer 25

The total value of goods and services produced in an economy at current prices, without adjusting for inflation.

Question 26

What is the formula for nominal GDP in the quantity equation?

Answer 26

PY, where P = price level and Y = real output.

Question 27

What is the difference between nominal and real GDP?

Answer 27

Nominal GDP includes inflation (current prices); real GDP is adjusted for inflation and reflects actual output.

Question 28

What can cause nominal GDP to increase?

Answer 28

A rise in the price level (P) A rise in real output (Y) An increase in money supply (M) (if V is constant)

Question 29

If the money supply increases and velocity is constant, what happens to nominal GDP?

Answer 29

Nominal GDP increases proportionally with the money supply.

Question 30

Why do economists sometimes assume velocity (V) is constant?

Answer 30

It simplifies the quantity equation and allows them to focus on how money supply (M) affects nominal output (PY).

Question 31

What are the three building blocks of the qty theory of money explaining the price level?

Answer 31

Output (Y) is determined by factors of production Money supply (M) is set by the central bank Price level (P) = Nominal GDP (PY) ÷ Real GDP (Y)

Question 32

What determines real output (Y) in this theory?

Answer 32

The economy’s factors of production and technology — assumed to be fixed in the short run.

Question 33

Why does an increase in the money supply (M) lead to higher prices (P) if output (Y) is fixed?

Answer 33

Because more money increases PY, and if Y is constant, the increase must come from P (higher prices).

Question 34

What is the GDP deflator?

Answer 34

A measure of the price level — it reflects the portion of nominal GDP growth due to price increases.

Question 35

How does the quantity theory explain inflation?

Answer 35

If V is constant and Y is fixed, increases in M lead to proportional increases in P, causing inflation.

Question 36

What is the quantity equation in percentage-change form?

Answer 36

%ΔM+%ΔV=%ΔP+%ΔY

Question 37

If velocity is constant and money supply grows by 7% while output grows by 2%, what is the inflation rate?

Answer 37

5%

Question 38

If M grows by 5% and Y grows by 3%, with constant V, what is the inflation rate?

Answer 38

2%

Question 39

Which variable in the percentage-change equation is controlled by the central bank?

Answer 39

The growth rate of the money supply (%ΔM)

Question 40

What happens to inflation if the central bank increases money growth and output doesn’t change?

Answer 40

Inflation rises — since nominal GDP rises and real output stays fixed, prices must increase.

Question 41

What is the immediate effect of an increase in the money supply?

Answer 41

It creates an excess supply of money — people hold more money than they want at the current price level.

Question 42

What is the result of people spending or lending their excess money?

Answer 42

It increases overall demand, raising the demand for goods and services across the economy.

Question 42

Why do people end up with more money than they need after a monetary injection?

Answer 42

Because at the prevailing price level, they already had enough money to make planned transactions.

Question 43

What are two ways people respond to excess money balances?

Answer 43

Spend more on goods and services Lend the excess by buying bonds or depositing in banks (who lend it out)

Question 44

Does long-run output increase when the money supply increases? Why or why not?

Answer 44

No — long-run output is fixed and depends on capital, labor, and technology, not money.

Question 45

Why does the price level rise in response to an increase in money supply?

Answer 45

Because with fixed output, higher demand leads to higher prices, not more production.

Question 46

How does the price level help restore equilibrium in the money market?

Answer 46

As prices rise, people need more money for transactions, so money demand rises, eventually matching the new money supply.

Question 47

What is the long-run effect of an increase in the money supply according to the adjustment process?

Answer 47

→ In the long run, increases in the money supply lead to higher prices, not more output — the demand expansion increases the overall price level.