ECON7074 Chap.8 Money, the Quantity Theory and Interest Rates
Money, the Quantity Theory and Interest Rates
This chapter explains what money is and how its long-run growth governs the price level. It starts from the idea that money is any asset accepted in payment, contrasts the barter story with modern fiat currency that holds value because people expect others to take it, and sets out the four jobs money does: medium of exchange, unit of account, store of value and means of settlement.
It then compares how the United States and Australia measure the money stock, from currency and the monetary base out to broad money, and why liquidity falls as the measures widen. The quantity equation is solved in levels and growth rates to link money growth, velocity and real growth to inflation.
The chapter closes with neutrality, the Fisher equation linking nominal and real interest, and the course reading on banks creating deposits when they lend. A worked example with falling velocity and a deposit-creation exercise show how each idea turns into exam-ready arithmetic.
What this chapter covers
- 01
What makes an asset money
- 02
The four functions of money
- 03
Monetary base, M1, M3 and broad money
- 04
The quantity equation and velocity
- 05
Neutrality and the classical dichotomy
- 06
Nominal, real and ex post interest rates
Worked example · free
Inflation from money growth when velocity is constant or falling
- +1Write the growth form of MV = PY: money growth plus velocity growth equals inflation plus real GDP growth.
- +1With velocity constant, inflation is 9 minus 3, which is 6% a year.
- +1Nominal GDP growth is inflation plus real growth, 6 + 3 = 9%, equal to money growth as expected with fixed velocity.
- +1With velocity falling 2% a year, 9 minus 2 equals inflation plus 3, so inflation is 4% a year.
Key terms
- Fiat money
- Currency with no commodity backing, given value by government declaration and by each holder's expectation that others will accept it.
- Medium of exchange
- The role of an asset that people hand over to buy goods and services, avoiding the need for a double coincidence of wants.
- Velocity of money
- How many times, on average, each unit of money is spent on final output during a year; equal to nominal GDP divided by the money stock.
- Classical dichotomy
- Proposition that in the long run real variables are determined separately from nominal ones, so money affects prices but not output.
- Monetary base
- Currency together with the reserves commercial banks hold at the central bank; the narrowest official money measure.
Money, the Quantity Theory and Interest Rates FAQ
Why does paper money have value if it is not backed by gold?
Modern currency is fiat money. Its value rests on expectations: each person accepts it because they are confident others will accept it in turn, and the government declares it legal for settling debts. In hyperinflations governments issue ever larger notes as money loses value.
What is the difference between M1, M3 and broad money?
They are progressively wider measures of the money stock. In Australia M1 adds current deposits to currency, M3 adds the other deposits held at banks, and broad money adds further deposit-like borrowings of financial institutions. Each step brings in assets that are slower to convert into cash, so the wider measures are less liquid.
How do you get inflation from the quantity equation?
Take growth rates of MV = PY so that money growth plus velocity growth equals inflation plus real growth. If velocity is constant, inflation equals money growth minus real GDP growth. Faster money growth raises inflation one for one, while faster real growth or falling velocity reduces it.
Is money neutral in the short run?
Not in the course's account. Neutrality says money changes only prices, and the evidence supports it over long horizons. Over short periods many nominal prices and wages adjust slowly, so a change in money growth can move output and employment for a while before prices fully catch up.
What is the difference between ex ante and ex post real interest rates?
The ex ante real rate subtracts expected inflation from the nominal rate and governs decisions when a loan is made. The ex post rate subtracts the inflation that actually occurred. When inflation surprises on the upside, the ex post real rate falls below the ex ante rate, favouring borrowers over lenders.
Exam move
Learn this chapter in three passes. First, memorise the four functions of money and be able to say why an asset that loses value fast fails as a store of value and then as a medium of exchange. Second, drill the quantity equation in growth rates with small numbers: change one of money growth, velocity or real growth at a time and predict inflation before calculating it.
Third, practise the Fisher equation in both ex ante and ex post form, always stating who gains when inflation surprises. Finish by explaining in two sentences how a bank loan creates a deposit, and when you would use the money multiplier story instead.
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