Short on time? This page is the recap. For explanations, the AD–AS graph and worked examples, use the full study guide.
Recap
- Inflation that lasts is caused by the money supply growing too fast for too long. A sustained fall in the money supply causes deflation.
- Equation of exchange: M × V = P × Y. It is always true, because velocity is defined as nominal GDP ÷ M.
- Quantity theory of money: velocity is stable and real output is fixed at full employment by real resources, so in the long run the growth rate of M sets the inflation rate.
- Long-run neutrality: at full employment, money changes nominal values only. Real GDP is unchanged in the long run.
- AD–AS story: more money shifts AD right; output rises above Yf in the short run; nominal wages rise and SRAS shifts left; output returns to Yf at a higher price level.
Key relationships
| Relationship | Formula | Use it to |
|---|---|---|
| Equation of exchange | M × V = P × Y | link money to spending |
| Velocity | V = nominal GDP ÷ M = (P × Y) ÷ M | find how often money is spent |
| Price level | P = (M × V) ÷ Y | find P from money, velocity and output |
| Real output | Y = (M × V) ÷ P | find real GDP |
| Money supply | M = (P × Y) ÷ V | find the money needed |
| Growth form (approx.) | %ΔM + %ΔV ≈ %ΔP + %ΔY | find long-run inflation from growth rates |
| Constant V | inflation ≈ %ΔM − %ΔY | the most common exam case |
Assumptions behind the numbers
- V is stable. If a question gives a change in V, include it.
- Y is at full employment in the long run (vertical LRAS).
- P is a price level (index ÷ 100), not an inflation rate.
- The growth-rate rule is an approximation; levels give the exact answer.
Mistakes to avoid
- Treating P as the inflation rate. Inflation is the % change in P.
- Forgetting real growth. 8% money growth with 3% real growth and constant V gives about 5% inflation, not 8%.
- Saying money raises real GDP in the long run. Only in the short run.
- Calling velocity an amount of money. It is a number of times per year.
- Confusing a one-time price rise with inflation. Continuing inflation needs continuing money growth.
- Ignoring a change in V when the question gives one.
Quick self-check
VD is the valda, the currency of the fictional country Valdoria used in the study guide.
- M = VD 150 billion and nominal GDP = VD 900 billion. What is V? (6)
- M = 300, V = 3, Y = 750. What is P? (1.2, an index of 120)
- Money grows 6% a year, V is constant and real GDP grows 2% a year. About what is long-run inflation? (4%)
- The economy is at full employment and M rises 10% once. What happens to real GDP and the price level in the long run? (Real GDP unchanged; price level 10% higher, if V is constant)
Next: practice questions.