5 Steps to a 5 AP Macroeconomics 2019

156 ❯ Step 4. Review the Knowledge You Need to Score High

rises to PL 2 and inflation becomes a concern. As the economy, now with more money in

circulation, adjusts to higher levels of spending, nominal wages and other factor prices rise,

shifting the SRAS curve to the left to SRAS 2. When the economy fully adjusts, it is back

at full employment, but the aggregate price level has now greatly risen to PL 3. Early mon-

etarists such as Milton Friedman would therefore argue that such activist monetary policy

doesn’t “fix” the recession, it only creates inflation in the long run. The monetarists believe

that the role of the central bank should be price stability, and the best way to accomplish

this goal is to gradually and methodically increase the money supply by a fixed percentage

each year.

Another way to see the monetarist view of monetary policy is to examine the equation

of exchange, the topic we turn to next.

Quantity Theory of Money

Fiscal policy directly puts money into, or takes money out of, the pockets of households

and firms, but monetary policy depends upon several cause-and-effect relationships. The

critical link between monetary policy and real GDP is the relationship between changes

in money supply, the real interest rate, and the level of private investment. After all, if the

money supply increases and there is no increase in investment, expansionary monetary

policy would have no effect on real GDP. As already noted, monetarists have become

proponents of the quantity theory of money, which postulates that increasing the money

supply has no effect on real GDP, but only serves to increase the price level.

One way to view this theory is to use the equation of exchange. The equation says that

nominal GDP (P × Q) is equal to the quantity of money (M) multiplied by the number of

times each dollar is spent in a year (V), the velocity of money. For example, if in a given

year the money supply is $100 and nominal GDP is $1,000, then each dollar must be spent

10 times; V = 10.

MV = PQ, or V = PQ/M

If the money supply (M) increases, this increase must be reflected in the other three

variables. To accommodate an increase in money supply, the velocity of money must fall,

the price level must rise, or the economy’s output of goods and services must increase.

Price

Level LRAS

Qr QfQ 2

SRAS 1

SRAS 2

AD 1

AD 2

PL 3

PL 2

PL 1

Real GDP

Figure 11.9