Economics bank

Monetary policy

Markets

Money

Europe

Monetary Policy - Inflation - Causes

Worksheet 2 - Money - can there ever be too much?

The aim of this worksheet is to look at the quantity theory of money. It looks at what the quantity theory is and the underlying assumptions, and then looks at the empirical evidence to make simple tests of its validity.

1. The Quantity Theory of Money is based on the Fisher Equation of Exchange. Fill in the blanks below to give the equation of exchange:

_______  x  ________  =  _______  x  ________

(4 Marks)

2. Write a short paragraph explaining why this equation is always true.

(4 Marks)

3. Classical economists made two assumptions about the equation of exchange to develop the Quantity Theory of Money. What were the two assumptions?

a)

b)

(2 Marks)

4. In the paragraph below delete words in bold as appropriate, so that it explains the Quantity Theory of Money correctly.

The Quantity Theory of Money is based on the Fisher Equation of Exchange. Classical economists took this equation and assumed that V would be relatively stable / volatile over the medium term. They also believe that the economy will tend to below full / full employment over time. This happens because if there is unemployment then there is a shortage / surplus of labour. This will push the level of wages down / up. If wages are then higher / lower firms will take on more / less people. Any unemployment has therefore been automatically corrected by the market raising / lowering wages.

Since the economy automatically tends to full employment in the view of classical economists, they argued that P / T in the Fisher equation would be stable in the medium term. Therefore any increase in the money supply would automatically lead to economic growth / inflation.

(8 Marks)

5. Use the data section to get data for the money supply and inflation and fill in the figures in the table below. You will need to use the following variables:

• VQUX M0 wide monetary base: annual % change
• VQJW Money stock M4: annual % change SA
• CZBH UK Retail prices all goods and services

Use the axes below (or use your spreadsheet program) to plot scatter graphs for money supply growth and inflation.

What relationship would you have expected between these two variables?

(6 Marks)

6. Draw on the graphs above a 'best-fit line' (or use your spreadsheet graphing function to do this). How close a fit is this line? Does the evidence appear to back up the quantity theory of money?

(4 Marks)

7. This test is a fairly simple one. What other factors would we have to take into account to do a more accurate test of the quantity theory of money?

(4 Marks)

Total Marks = 32