Page 520 - Introduction to Business

494 PART 5 Finance

MV PQ
where M the money supply in the country, V the velocity of money (i.e., the
average number of times that a dollar changes hands per year), P the average
price level of goods and services in the economy, and Q the quantity of goods and
services sold. If we consider the rate of change in these variables over time, we can
rewrite the equation as follows:
m v p q
where m the rate of growth of the money supply, v the rate of change of the
velocity of money (normally considered to be zero), p the rate of change in the
prices of goods and services, known as the inflation rate, and q the rate of growth
of the real economy. An important implication of this equation is that the money
growth rate on the left-hand side is linked to the economic growth rate on the right-
hand side. Not only does an increase in the money supply tend to decrease interest
rates, as already shown in Exhibit 14.3, but it also increases the funds available to
the public to buy goods and services and thereby stimulates business production.
In short, money matters!
As an example, assume that the velocity of money v is zero and that the growth
rate of money m is 5 percent. If the inflation rate p is 2 percent, we know that the
growth rate of the economy q will be 3 percent. The central bank could increase the
growth rate of the economy to 4 percent by increasing the growth rate of money to
6 percent, where we have assumed that the inflation rate will stay at 2 percent.
Notice that rate of growth of the economy will increase in response to money
growth as long as the inflation rate does not increase. We can measure the rate at
which prices are rising by rearranging the equation as p m q, where v 0. Here
we see that if the growth rate of money implemented by the central bank exceeds
the growth rate of the economy, as measured by change in the gross national prod-
uct, then inflation, an increase in the average prices of goods and services, will
occur.
One problem in the equation of exchange is that money supply growth does not
immediately result in growth of the economy. We know that there are long and vari-
able lags between changes in money supply and increases in productivity; that is,
increases in the money supply today will take some amount time before they affect
the growth of the economy. Some economists have argued that, given this lag is
unpredictable, monetary policy should simply establish a fixed growth rate of
money and not change it. However, because money does matter to the economy
and monetary policy seeks to achieve economic goals, some amount of fine tuning
of the money supply is typically used to speed up or slow down the economy. If the
economy is growing faster or slower than desired, the Fed can decrease or increase
money supply growth rates in an effort to maintain more stable economic growth
over time. The downside of fine tuning the money supply is that this type of discre-
tionary monetary policy can cause higher inflation. For example, if the money sup-
ply is increased today but for some reason the growth rate of the economy does not
increase in the future, then “too much money will be chasing too few goods” and we
will have an increase in inflation. Since it is generally true that central banks around
the world seek to maintain low and stable prices by controlling inflation rates, it is
common to set a fixed range of money growth, say, 3 to 5 percent, and fine-tune
only within this target range.

Definitions of Money. In the 1950s, central banks began classifying money
into different types. The following definitions of money have developed over the
years:

Copyright 2010 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.