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6.3.5 Money, Prices, and Inflation
After studying different versions of quantity theory of money, we now have a theory to
explain what determines the economy’s overall level of prices. The theory has three building
blocks. Before going to study three building blocks, let us know some important related
concepts like factors of production and the production function that helps us to understand
three building blocks. The factors of production like land, labour, capital, and entrepreneurs
that are uses as inputs to produce goods and services. The two most important factors of
production are capital (K) and labour (L). Capital is the set of tools that workers used while
producing goods and services while labour is the time people spend working.
The available production technology determines how much output is produced from
given amount of capital and labour. Economists express the available technology using a
production function. Letting Y denotes the amount of output, we write the production
function as:
Y = f (K, L)
6.28
The equation states that output (Y) is a function of the amount of capital and the amount of
labour.
The production function reflects the available technology for turning capital and
labour into output. If new technology is invented for the production of goods and services,
then the result is more output with the same amount of capital and labour. Thus,
technological change alters the production function.
Having understood the concept, let us move to explain what determines the
economy’s overall level of prices. This depends on three elements:
1.
The factors of production and the production function determines the real level of
output (Y);
2.
The money supply determines the nominal value of output (PY). This conclusion
follows from the quantity equation and the assumption that the velocity of circulation
of money is fixed (V);
3.
The price level, P is then the ratio of the nominal value of output (PY) to the real
output (Y). For example, suppose economy produces 2000 mangoes and the price of
one mango is Rs.10. So that,
P =
,
-
-.
/.
. ( 1)
- /.
. (1)
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P =
.( 3
4
=
.
,
=
Rs. 10 per unit of mango.
In other words, the productive capability of the economy, determines real gross domestic
product ( GDP), and the quantity of money determines the nominal GDP, and the GDP
deflator is the ratio of nominal GDP to real GDP, so that
GDP Deflator =
,
- 67
- 67
6.30
The theory behind GDP deflator reflects up-to-date expenditure patterns. For instance,
if price of mangoes increases relative to the price of guava, it is claimed that people will
likely spend more money on guava as substitute for mangoes.
This theory explains what happens when the velocity of circulation of money (V) is
fixed and the Reserve Bank of India changes supply of money. In this situation increase in
supply of money leads to a proportionate change in nominal GDP because V is fixed. Change
in nominal GDP represents a change in the price level. Hence, the quantity theory of money
implies that the price level is proportional to the money supply.
As we know that inflation rate is the percentage change in the price level, this theory
of the price level is also the theory of the inflation rate. The quantity equation, MV = PY
when written in percentage- change form, is
% change in M + % change in V = % change in P + % change in Y, or
%
∆
M + %
∆
V = %
∆
P + %
∆
Y
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Where, %
∆
M refers to the percentage change in supply of money, which is under the control
of monetary authorities i.e. the Reserve Bank of India; %
∆
V stands for percentage change in
the velocity of circulation of money and it is assumed as constant, so the percentage change
in velocity is zero; %
∆
P is percentage change in the price level; and %
∆
Y
refers
to
the percentage change in real output, which depends on factors of production and production
function (i.e., technological progress). For the time being we take production function as
given and with constant V, changes in money supply will directly affect price level as factors
of production and production function have already determined real GDP. This analysis tells
us that (except for a constant that depends on exogenous growth in output) the growth in the
money supply determines the money supply.
Thus, the quantity theory of money states that the central bank, which controls the money
supply, has ultimate control over the rate of inflation. if the central banks keeps the money
supply stable, the price level will be stable, if the central bank increases the money supply
rapidly, the price level will rise rapidly
8
.“Inflation is always and everywhere a monetary
phenomenon” so wrote Milton Friedman, the great economist who won the Nobel Prize in
economics in 1976. The quantity theory of money leads us to agree that the growth in the
quantity of money is the primary determinant of inflation rate
9
.
The quantity equation can be viewed as a definition: it defines velocity, V as the ratio
of nominal GDP (i.e.,PY) to the quantity of money (M) such as V = PY/M. If we make the
additional assumption that the velocity of money is constant, then the quantity equation
becomes a useful theory of the effects of money, called the quantity theory of money
10
.
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