Question

1. What is The Quantity Theory of Money and what is the implication for the price level in the long run using that theory?
2. How to calculate the inflation rate using the Quantity Theory of Money?
3. How to find the real interest rate?
4. What are the costs of inflation and what is inflation tax?

Answer 1

The quantity theory of money says the price levels of services and goods are directly proportional to the money supply in the economy.

M*V=P*T

where,

M stands for money supply

V stands for velocity of money

P stands for price and

T stands for number of transactions

When the level of money is doubled, then price also gets doubled.

M*V=P*T

T gets replaced by Y. Then the equation becomes,

M*V=P*Y

where Y stands for output.

Growth rate of money supply+Growth rate of velocity of money=Inflation rate+Growth rate of output

Using this equation, inflation rate can be calculated.

For finding real interest rate, inflation rate is deducted from nominal interest rate, that is,

Real interest rate= Nominal interest rate- Inflation rate

The costs of inflation are shoe leather cost, menu cost, loss in purchasing power of money.

Inflation tax is defined as the penalty of holding money/cash at the time of inflation.