Relationship Between the Money Supply and Nominal Gdp

I. Introduction to hypothesis

In estimating the relationship between the money supply and nominal GDP we look into the past to find the many different ways that the great economists of the past studied this relationship. The first thing to understand is that money supply should be considered the same thing as money demand, this happens in our equilibrium society that I am using for this paper. Therefore anytime equations may differ depending on money supply and money demand we will just assume that they mean the same thing in that M = M , but only in a equilibrium economy. Lets attempt to assume equilibrium for the ease of the equations at hand. Next we must understand a basic money supply equation, in which the money supply is equal to the price level multiplied by income and that number is then divided by the velocity (or the number of times per year a dollar turns over). The equation would look like this:

M = PY / V

The relationship between money supply (M ) and nominal GDP (PY), should be looked at as either PY is a function of M (or M ) or that Ms is a function of PY. Combining these we can find the M by making M a function of P and Y. Of course I will try to use the other economists and other literature sources to prove this hypotheses. For instance the classical economists believed that money was a function of price and the output level. Price and output give you nominal GDP, therefore they thought that money supply was a function of (simply enough) the nominal GDP. Keynes changed that thought to state that the money supply was a function of price and the incomes. My argument is the derived oppisite of the classical in that the nominal GDP is a function of the money demand. Therefore the dependent variable running would be GDP as the equation might start as: PY= f(M ).

II. Theoretical rationale

Theoretically this study is important to develop and understanding of why a county would decide to supply more or less money to its citizens in order to develop a higher GDP and a feeling of stability and growth. The other possibility is of course to discover a chance of recession before it happens by unveiling the chance of possible downturns in GDP through the lowering of the national money supply. Other reasons for testing this theory would be to decide what other independent variables might contribute to nominal GDP. For instance, does government spending, and cuts in taxes increase or decrease the PY. We can discover these things practically through the aggregate demand curve and its relations to the money market. Aggregate demand shows the combinations of the price level and level of output at which money markets and goods are simultaneously in equilibrium. In other words an increase in the money supply shifts the aggregate demand upward. Leaving out some elements of the aggregate demand and only studying money supply can help us discover our previous equation. If the central bank provides M dollars, then M x V = P x Y. we must then assume that V (the velocity of money) is constant. Therefore an increase in the money output shifts nominal GDP up. This different assumptions and theoretical evaluations and equations prove the previous equation, M = PY / V.

III. Review of literature

Many arguments and discussions came from the money supply equation. Classical economists determined that the velocity of money did not change and that, M = f (P,Y). Keynesian economics declared that V was subject to change and that with velocity changing that the, M = f (P,I). The difference that Keynes brought was that money demand was a function of investment and not of income. Another econometrician by the name of Friedman wrote that the term velocity refers to the ratio of the quantity of money and the price level. He researches the quantity of money to find its origin. He thus explains “the quantity theory is in the first instance a theory of the demand for money.” (Friedman, 4) He explains that three things contribute to the demand for money, which are; 1. a total wealth to be held (budget restraint), 2. the return on types of wealth, and 3. tastes and preferences of the people with the wealth. He represents the demand for money as a function of nominal income, change in price level, the value of physical goods (like assets), and total wealth. One variable that is believed to be left out of the equation he feels is the volume of transaction demands, and that transactions per dollar should be a part of the money demand. The banks, he mentions are not noted, because they have no connection to the supply of money rather then just a demand for it as well, for it is the central bank that decides that supply, and everyone else is just demanding it. He comments that with all