or simplicity and elegance, it’s hard to beat the equation of exchange. MV=PY. Money expenditures equal the dollar-value of output. With four easy-to-understand variables, we get a highly useful framework for interpreting monetary policy.
The equation of exchange is also readily modifiable into a testable theory. Assuming (1) stable velocity (V) and (2) non-monetary factors determine output (Y), we get the quantity theory of money. This asserts a one-for-one relationship between the money supply and the price level. Classic monetarism gets a bad rap these days, but frankly it’s better than much of the atheoretical hocus-pocus that currently passes for sophisticated policy analysis.
Remember, the equation of exchange is a tautology. We’re defining velocity as the ratio of nominal income (PY) to the money supply (M). The equation of exchange provides a helpful way to organize our thoughts, but its ultimate economic justification isn’t specified. Can we find a microeconomic foundation for velocity? As it turns out, we can. It hinges on the demand to hold money.
The simplest theory of money demand asserts that we hold a fraction of our nominal income as cash. Instead of investing it, we keep some of our savings in highly liquid forms, such as demand deposits. These aren’t literally cash—bank liabilities denominated in dollars are not the same thing as actual dollars created by the Federal Reserve—but provided the bank in question and the overall banking system is sound, they’re as good as cash. (When claims to dollars aren’t viewed as near-perfect substitutes for dollars, bad things happen.) We can think of these holdings as precautionary balances: insurance against out-of-nowhere economic shocks. more at:
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