Chapter 13 Outline
V. THE CAUSES OF INFLATION
A. The Quantity Theory of Money
	1. The quantity theory of money emphasizes that the money supply is the main determinant of nominal GDP.
	2. The quantity theory of money is explained by referring to the equation of exchange.
	a. The equation of exchange shows the relationship between the money supply, the income velocity of money, the GDP deflator, and real GDP.
		1. The income velocity of money is the number of times the money supply is used to purchase final goods and services during a year.
	b. The equation of exchange states that the money supply times the income velocity of money is equal to the GDP deflator times real GDP.
	3. The quantity theory of money assumes that the velocity of money is constant.
	a. If velocity is constant, its growth rate is zero and the growth rate in the money supply will equal the inflation rate (the growth rate of the GDP deflator) plus the growth rate in real GDP.
		1. This also means that the inflation rate is equal to the growth rate of the money supply minus the growth rate of output.
		a. If the money supply grows at the same rate as output, the price level will be stable.
		b. If the money supply grows faster than output, the economy will experience inflation.
B. Inflation Is a Monetary Phenomenon
	1. Inflation is said to be a monetary phenomenon because excessive growth rates of the money supply cause inflation.
C. Inflation as a Monetary Phenomenon: Two Qualifications
	1. If output does not grow at a constant rate, the relationship between inflation and the money supply is not as strong.
	a. If the growth rate of output is not constant, inflation will vary even if the growth rate in the money supply is constant.
	2. If the income velocity of money is not constant, the relationship between inflation and the money supply is not as strong.
	a. If the growth rate in velocity is not constant, inflation will vary even if the growth rate in the money supply is constant.
D. Labor Unions, Monopolies, and Inflation
	1. Some economists argue that inflation occurs as labor unions force wages up and firms pass the increased cost on to consumers in the form of higher prices.
	2. Many economists feel that labor unions do not make a major contribution to inflation.
	a. Many unions lack significant bargaining power.
	b. Only about 15 percent of the nonagricultural labor force belong to unions.
	c. Workers who cannot find jobs in the union sector turn to nonunionized sectors of the economy where wages are forced down.
	3. Some economists argue that monopolies contribute to inflation by restricting output and charging higher prices for products than would occur under competition.
	a. Increases in prices would cease once the monopolist reached the profit maximizing price; hence, increases in prices would cease, and inflation (a continuing increase in the price level) would not be a problem in monopolistic settings.

[Return to Textbook Materials Page