Question

Is the quantity theory of money better able to explain the inflation rate in the long run or in the short run? Briefly explain.

Short answer

The Quantity Theory of Money is better able to explain the inflation rate in the long run. This is due to the theory's basic assumptions assuming stable rates in variables impacting the economy over the long run, thereby making it less applicable to short run scenarios where other factors can play a significant role.

Step-by-step solution

Understand the Quantity Theory of Money

The Quantity Theory of Money, implies that there is a direct relationship between the quantity of money in an economy and the level of prices of goods and services sold. It states that if there is a change in the supply of money, there is a proportionate change in the level of price.

Consider the theory’s application in the short-run

In the short-run, the relationship between quantity of money and the inflation rate may appear unpredictable. Various factors such as the velocity of money (the rate at which money changes hands), people's response to price changes, monetary policies, and temporary economic phenomena can have a strong influence over the inflation rate. Increasing money supply may not always immediately lead to higher inflation as there could be lags in the economy's response.

Consider the theory’s application in the long-run

In the long-run, many of these short-run complications are smoothed out with a clear relationship between money supply and inflation prevailing. Moreover, given that Velocity and Real GDP are constant or growing at stable rates in long run, more money leads to higher prices, i.e. inflation. Economists generally agree that in the long run, inflation is primarily a monetary phenomenon.

Conclude the analysis

Given that the Quantity Theory of Money approximates behavior over the long run by assuming variables such as money velocity and Real GDP are constant or stable, we can say that it is more able to explain the inflation rate in the long run, as opposed short term volatility where other factors can play a significant role.

Key concepts

Inflation Rate

Inflation is often depicted as the 'boogeyman' of the economy, a phenomenon that reduces purchasing power and can erode savings. In simple terms, the inflation rate is the rate at which the general level of prices for goods and services is rising, and, subsequently, how it affects the purchasing power of currency.

For example, with an annual inflation rate of 5%, a loaf of bread that costs \(1 today would cost \)1.05 next year. When trying to understand inflation, it's crucial to recognize that it doesn't just represent a bump in prices, but a devaluation of the money itself.

The Quantity Theory of Money ties into this as it suggests that inflation is related to the money supply. An increase in the money supply can dilute the value of each currency unit, meaning it takes more money to buy the same goods and services – hence, inflation. However, inflation may not always be in lockstep with changes in money supply due to many variables, including economic policies and consumer behavior, which can be particularly divergent in the short run. In contrast, in the long run, the correspondence between money supply and price levels tends to be more predictable and stable.

Money Supply

The 'money supply' refers to the total volume of currency and other liquid instruments circulating in an economy at any given time. It is not just physical cash but includes checking deposits, savings deposits, and other forms of money that are easily accessible for spending.

Central banks, like the Federal Reserve in the United States, play a pivotal role in regulating the money supply through various mechanisms such as setting interest rates, reserve requirements for banks, and conducting open market operations. The interaction between these tools determines the ease with which money can flow through the economy.

Levels of Money Supply

There are several different measures of money supply, M0, M1, M2, and so forth, each including a larger range of money types.

• M0 is the most liquid form, comprising of cash and coins.
• M1 adds demand deposits and checking accounts.
• M2 includes everything in M1, plus savings accounts, money market accounts, and other types of near money.

In the Quantity Theory of Money, an increase in the money supply, if not matched by an increase in economic output, is generally thought to lead to inflation over time, as it means more money is chasing the same amount of goods and services.

Velocity of Money

Velocity of money, in essence, is a measure of how briskly money is moving around an economy. It tells us the number of times one unit of currency (like a dollar) is used to purchase domestically-produced goods and services within a certain period of time.

Higher velocity means money is being frequently exchanged, which can indicate a healthy economic activity where people are buying and selling goods rapidly. On the other hand, a lower velocity suggests that money is changing hands less frequently, possibly implying economic stagnation or cautious consumer behavior.

How does this tie back to inflation and the quantity theory of money? Well, if the velocity of money is high, even a stable or slightly growing money supply can lead to inflation because the same money is used for more transactions. Conversely, if the velocity is low, an increase in money supply might not lead to inflation immediately because it's not 'circulating' as fast – people may be holding on to their cash rather than spending it. In the long run, however, the theory considers the velocity to be fairly stable and predictable, which swings the focus back to the money supply as a determinant of inflation.