THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 585

CHAPTER 21 The Demand for Money 553 Irving Fisher reasoned that velocity is determined by the institutions in an economy that affect the way individuals conduct transactions If people use charge accounts and credit cards to conduct their transactions, as they can today, and consequently use money less often when making purchases, less money is required to conduct the transactions generated by nominal income (M falls relative to P * Y ), and velocity (P * Y )/M will increase Conversely, if it is more convenient for purchases to be paid for with cash or cheques (both of which are money), more money is used to conduct the transactions generated by the same level of nominal income, and velocity will fall Fisher took the view that the institutional and technological features of the economy would affect velocity only slowly over time, so velocity would normally be reasonably constant in the short run Quantity Theory of Money Fisher s view that velocity is fairly constant in the short run transforms the equation of exchange into the quantity theory of money, which states that nominal income is determined solely by movements in the quantity of money When the quantity of money M doubles, M * V doubles and so must P * Y, the value of nominal income To see how this works, let s assume that velocity is 5, nominal income (GDP) is initially $5 trillion, and the money supply is $1 trillion If the money supply doubles to $2 trillion, the quantity theory of money tells us that nominal income will double to $10 trillion (+ * $2 trillion) Because the classical economists (including Fisher) thought that wages and prices were completely flexible, they believed that the level of aggregate output Y produced in the economy during normal times would remain at the full-employment level, so Y in the equation of exchange could also be treated as reasonably constant in the short run The quantity theory of money then implies that if M doubles, P must also double in the short run because V and Y are constant In our example, if aggregate output is $5 trillion, the velocity of and a money supply of $1 trillion indicate that the price level equals because times $5 trillion equals the nominal income of $5 trillion When the money supply doubles to $2 trillion, the price level must also double to because times $5 trillion equals the nominal income of $10 trillion For the classical economists, the quantity theory of money provided an explanation of movements in the price level Movements in the price level result solely from changes in the quantity of money Quantity Theory of Money Demand Because the quantity theory of money tells us how much money is held for a given amount of aggregate income, it is in fact a theory of the demand for money We can see this by dividing both sides of the equation of exchange by V, thus rewriting it as M = * PY V where nominal income P * Y is written as PY When the money market is in equilibrium, the quantity of money M that people hold equals the quantity of money demanded Md, so we can replace M in the equation with Md Using k to represent the quantity 1/V (a constant because V is a constant), we can rewrite the equation as M d = k * PY (3)