Expansionary Policy & Quantity Theory of Money (QTM)

Expansionary Policy & Quantity Theory of Money (QTM)
Expansionary policy means:
Increase in MONEY SUPPLY (M), and so AGGREGATE DEMAND (AD) rises

**Quantitative easing in US, Japan

For QTM:

MV = PY, whereas V is usally constant

M = Money Supply
V = Velocity of circulation of money
P = General Price Level
Y = Real Output
PY = Nominal Output
Yf = Potential output

Situation I: When DEFLATIONARY GAP occurs

If deflationary gap occurs, unemployment needs to be solved.
Ye < Yf, equilibrium output is less than potential output.
Increase in AD will lead to an increase in general price level, thus output (Y) will also increase.

Effect of expansionary monetary policy
Full employment occurs, potential output (Yf) obtained.

Apply quantity theory of money (QTM):
MV = PY (assume V is constant)
M increases, lead to rise in P and Y.
(% rise in M) -> (% rise in P) +  (rise in Y)
Growth rate in money supply = Inflation rate + Growth rate of real GDP or real output

Situation II: When deflationary gap DOES NOT occur

Suppose deflationary gap does not occur. So, full-employment happens.

Ye = Yf, the equilibrium output is equal to potential output.

In the short run, increase in M and AD will cause general price level and output to rise.

Original Ye = Yf. But money supply increases, so Ye rises above Yf. Ye > Yf

In the long run, when general price level rises, cost of production rises, shifting SRAS to left.

Short run aggregate supply (SRAS) decreases, and so output (Ye) falls back to potential output (Yf).

Hence, Ye = Yf. However, gerneral price level (P) will rise further more.