THE MONETARY EQUATION OF EXCHANGE AP Macroeconomics

MV = PQ  M = SUPPLY OF MONEY (M1)  V = THE NUMBER OF TIMES PER YEAR THE AVERAGE DOLLAR IS SPENT ON FINAL GOODS AND SERVICES  P = THE PRICE LEVEL OR THE AVERAGE PRICE AT WHICH EACH UNIT OF PHYSICAL OUTPUT IS SOLD  Q = THE PHYSICAL VOLUME (QUANTITY) OF ALL GOODS AND SERVICES PRODUCED, AKA REAL OUTPUT MVPQ

MV = PQ  Represents the total amount SPENT by purchasers of output  Represents the total amount RECEIVED by sellers of that output MVPQ

Discussion on Velocity  Velocity (V) is highly predictable with its value remaining in a very narrow range over a multi-year period.  It gradually increases, it is stable!  Why?  Shorter pay periods, greater use of credit cards, ATM/debit machines  Thus, changes in money supply (M) result in changes in nominal GDP (PxQ)!  Depending on state of the economy, the changes in the money supply can result in changes in prices, changes in output, or some combination of the two.

Activity 36 – Question 1  M = Money supply (M1)  V = Velocity (The # of times per year the average dollar is spent on final goods/services)  P = Price level (The average price at which each unit of physical output is sold)  Q = Quantity (Real output)

Activity The product of velocity (V) and the money supply (M) equals PQ. How can PQ be defined? Answer: Nominal GDP. 3. Suppose velocity remains constant, while the money supply increases. Explain how this would affect nominal GDP. Answer: Nominal GDP (PQ) would increase. What if the economy is not at full employment? Answer: both P and Q would increase What if the economy is at full employment? Answer: P would increase, but not Q (inflation)

Activity During the past 30 years, the use of credit cards has increased, and banks and financial institutions increasingly use computers for transactions. Explain how these changes might affect velocity. Answer: V would increase. A given stock of M could “work harder” and finance more transactions more quickly. 5. As the result of legislative and regulatory reform throughout the 1980s and 1990s, banks and other financial institutions began paying interest on a significant proportion of the checkable deposits in the M1 definition of money supply. Explain how these changes might be expected to affect the velocity of M1? Answer: V would decrease. People would be more willing to hold (not spend) M if it paid interest.