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Quantity Theory Of Money Essay

1049 words - 5 pages

Quantity theory of money is a basic topic that one should have general ideas about in order to understand the long run relationship between prices and inflation in macroeconomics class. One of the central implication of the theory basically states that countries which have higher money growth tend to have higher inflation rate. The quantity theory of money has been supported by data from many countries and for different periods of time. A common way would be used in this paper to provide proof for the theory is through computing average inflation, money growth, and real GDP growth from at least 30 countries in a cross section of 10 years or more. If the growth in money velocity is constant, ...view middle of the document...

Some sorts of external sector problems would lead to inflation are balance of payments and exchange rate. Inflation results in a loss of international competitiveness that if a country has a higher rate inflation than other competing countries, its goods and services will become less price competitive. Its exports become relatively expensive and imports relatively cheaper. This will worsen the balance of trade in the current account. When demand for exports decreases during inflation, foreigners’ demand for the home currency will decrease, and when the home country’s import demand increases, its demand for foreign currencies will rise. If a country’s inflation rate is higher than that of a trading partner’s, the country will experience a depreciation of its currency. In other words, tensions with prices must be looked on the supply side and external sector, not the supply of money. It is somehow true because in the short run, money supply does not tend to affect the price, as the relationship is inelastic. As opponents of the Quantity Theory of Money have stated, price tends to be sticky in the short run, leading to the rejection of the theory in its questionable parts.
However, the purpose of this paper is to test the accuracy of quantity theory of money in the long run. Basically, the quantity equation (MV = PY) says that: percent growth in the money supply + percent growth in money velocity = percent growth in prices + percent growth in real GDP. If the growth in money velocity is zero, then we have: percent growth in prices = percent growth in the money supply - percent growth in real GDP. In order to test the consistency of the theory across countries, some economists have collected data about average inflation, money and income growth from different countries for different time periods and set up graphs from the data.
The table below uses four different data sets to examine the accuracy of the quantity theory. Barro’s data set compute average inflation, money and income growth for a cross section of 79 different countries for various time periods after 1950. Dwyer and Hafer provides the same data for the 1961-1978 period from 62...

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