Monetary Policy and the Fed

Monetary Policy and the Equation of Exchange

Learning Objectives

1. Explain the meaning of the equation of exchange, MV = PY, and tell why it must hold true.
2. Discuss the usefulness of the quantity theory of money in explaining the behavior of nominal GDP and inflation in the long run.
3. Discuss why the quantity theory of money is less useful in analyzing the short run.

So far we have focused on how monetary policy affects real GDP and the price level in the short run. That is, we have examined how it can be used - however imprecisely - to close recessionary or inflationary gaps and to stabilize the price level. In this section, we will explore the relationship between money and the economy in the context of an equation that relates the money supply directly to nominal GDP. As we shall see, it also identifies circumstances in which changes in the price level are directly related to changes in the money supply.