Calculate real and nominal money economic growth rates using

Let us make an in-depth study of the Quantity Theory of Money.

To calculate your annual salary in real wages, you can choose between three formula variations, but they all produce the same outcome. Here is how to calculate your real annual salary if your nominal salary is $40,000 and the inflation rate is 1.2%: Formula one: Real Income = Wages - (Wages x Inflation Rate) Real Income = $40,000 - ($40,000 x 1.2%). .Velocity. the number of times in a year that an “average” dollar gets spent on goods and services; for example, if the velocity of money is 2, then every dollar in an economy gets used twice in a year.Money neutrality. the concept that money only impacts nominal variables, not real variables, in the long run; in other words, increasing the money supply might decrease the nominal.

The quantity theory of money, how the quantity of money is related to prices and incomes.

This point may now be explained in detail.

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Transactions and the Quantity Equation:

People hold money mainly for transactions purposes, i.e., to buy goods and services. If people want to exchange more goods and services they need more money. So the more money people need for transactions, the more money they demand and hold. The demand for money is related to the quantity of money because the money market reaches equilibrium when the two are equal.

The Quantity Equation of Exchange:

The link between the volume of transactions and the quantity of money is expressed in the following equation called the quantity equation of exchange:

Money supply x velocity of circulation = price level x volume of transactions

or, M x V = P x T … (1)

In this equation T, on the right hand side, represents the total number of transactions per period, say, one year. In others words, T denotes the number of times in a year goods or services are exchanged for money. P is the number of rupees exchanged per transaction. In other words, it is the price of an average transaction. The product of the two, i.e., PT, is the number of rupees exchanged per year.

M, on the left hand side of the equation, is the quantity of money and V is called the transactions velocity of money or the rate of money turnover, i.e., the number of times a unit of money circulates in the economy. In other words, velocity tells us the number of times a unit of money such as a rupee coin or a rupee note changes hands in a given period of time.

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Basically an Identity:

The equation of exchange is basically an identity, a truism. If any of the variables in the equation changes, one, two or three others have also to change to maintain the equality. Thus, if M increases and V remains constant, then either P or T has to rise.

From Transactions to Income:

Since it is difficult, in practice, to measure the number of transactions in an economy, economists have replaced T by the total output of the economy Y (which is also a measure of total income). T and Y are not the same, but they are related to each other. If Y increases T also has to rise. The more output is produced, the more goods are bought and sold by the people.

In a broad sense, the rupee value of transactions is proportional to the rupee value of output. Therefore PT can be replaced by PY and we can express the quantity equation as

MV = PY … (2)

where Y = the amount of output produced per year or GDP. Since Y is also the total income earned by the productive factors, V in equation (2) is called the income velocity of money. It indicates the number of times a unit of money is received as income per period (i.e., say, one year).

The Demand Function for Money and the Quantity Equation:

While analysing the effect of money on the economy, economists often express the quantity of money in terms of the quantity of goods and services it can buy. This is known as real money balance and is expressed as M/P, which measures the purchasing power of the quantity of money in circulation (or the stock of money in existence).

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A money demand function is expressed as

(M/P)_d = kY … (3)

where k is the fraction or proportion of income people want to hold for the purpose of transactions. Equation (3) states that the quantity of real money balances demanded is proportional to real income. Since money facilitates transactions, people want to enjoy the convenience of money holding. Since people want to buy more goods and services when their incomes rise, the demand for real balances increases when income rises.

Since the equilibrium condition of the money market is that the demand for real balances (M/P)^d is equal to its supply (M/P), we have

(M/P) = kY

or, M(/k) = PY

or, MV = PY … (4)

where V = 1/k. Equation (4) shows the link between the demand for money and its velocity. When people want to hold a large quantity of money for each rupee of income (k is large), money changes hands slowly (V is small).

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The converse is also true: when people want to hold only a small quantity of money (k is small), money changes hands very fast (V is large). So an important prediction of the quantity equation is that the money demand parameter k and the velocity of money V are the two (opposite though) sides of the same coin.

The Assumption of Constant Velocity:

The quantity equation is just a definition. It defines velocity Vas the ratio of PY (nominal GNP) and M (the nominal quantity of money). If we make the assumption that V remains constant, then the quantity equation is converted into a hypothesis, viz., the quantity theory of money. This theory is very useful for analysing the effects of money on the economy.

However, in reality, velocity changes as soon as the money demand function changes. With the introduction of ATM system, people reduced their average money holdings. This led to a fall in k (the parameter of the money demand equation) and a corresponding increase in velocity.

In spite of this the assumption of constancy of V provides a good approximation in many situations. Assuming that V is constant, we may analyse the effect of the money supply (M) on the economy.

As soon as we make the assumption that V = V̅ (a constant), the quantity equation becomes a theory of determination of nominal GDP. Thus the equation becomes

MV̅ = PY … (5)

where V̅ means a fixed value of V. In this case, a change in the quantity of money (M) will cause an exact proportionate change in nominal GDP (PY). Thus, if V remains fixed, the quantity of money (M) determines the money value of the economy’s output, its nominal GDP.

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Money, Prices and Inflation:

The three building blocks (ingredients) of the quantity theory of money are:

1. The economy’s level of output Y = GDP is determined by the factors of production and the production function.

2. The nominal value of output, PY, is determined by the money supply (if V remains constant).

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3. The general price level P is then the ratio of the nominal value of output, PY, to the level of output Y.

Alternatively stated, the quantity theory of money is based on the propositions that (i) real GDP is determined by the economy’s productive capability, (ii) nominal GDP is determined by M (the quantity of money); and (iii) the GDP deflator is the ratio of nominal GDP to real GDP.

Effect of changes in M on P:

The main prediction of the quantity theory of money is that, if V remains constant, any change in M, effected by the central bank, leads to an exact proportionate change in nominal GDP.

Since real GDP remains constant in the short run when factor supplies remain fixed and technology (which determines the production function) remains unchanged, any change in nominal GDP must represent a change in the general price level (P). Thus, according to the quantit

Calculate Real And Nominal Money Economic Growth Rates