Quantity theory of money
The foundation stone of MONETARISM. The theory says that the quantity of MONEY available in an economy determines the value of money. Increases in the MONEY SUPPLY are the main cause of INFLATION. This is why Milton FRIEDMAN claimed that “inflation is always and everywhere a monetary phenomenon”.
The theory is built on the Fisher equation, MV = PT, named after Irving Fisher (1867–1947). M is the stock of money, V is the VELOCITY OF CIRCULATION, P is the average PRICE level and T is the number of transactions in the economy. The equation says, simply and obviously, that the quantity of money spent equals the quantity of money used. The quantity theory, in its purest form, assumes that V and T are both constant, at least in the short-run. Thus any change in M leads directly to a change in P. In other words, increase the money supply and you simply cause inflation.
In the 1930s, KEYNES challenged this theory, which was orthodoxy until then. Increases in the money supply seemed to lead to a fall in the velocity of circulation and to increases in real INCOME, contradicting the classical dichotomy. Later, monetarists such as Friedman conceded that V could change in response to variations in M, but did so only in stable, predictable ways that did not challenge the thrust of the theory. Even so, monetarist policies did not perform well when they were applied in many countries during the 1980s, as even Friedman has since conceded.
Random walk
Impossible to predict the next step. EFFICIENT MARKET THEORY says that the PRICES of many financial ASSETS, such as SHARES, follow a random walk. In other words, there is no way of knowing whether the next change in the price will be up or down, or by how much it will rise or fall. The reason is that in an efficient market, all the INFORMATION that would allow an investor to predict the next price move is already reflected in the current price. This belief has led some economists to argue that investors cannot consistently outperform the market. But some economists argue that asset prices are predictable (they follow a non-random walk) and that markets are not efficient.
Real balance effect
Falling INFLATION and INTEREST rates lead to higher spending (see WEALTH EFFECT).
Real exchange rate
An EXCHANGE RATE that has been adjusted to take account of any difference in the rate of INFLATION in the two countries whose currency is being exchanged.
Real interest rate
The INTEREST RATE less the rate of INFLATION.
Reflation
Policies to pump up DEMAND and thus boost the level of economic activity. Monetarists fear that such policies may simply result in higher INFLATION.
Relative income hypothesis
People often care more about their relative well being than their absolute well being. Someone who prefers a $100 a week pay rise when a colleague gets $50 to both of them getting a $200 increase, for example. Poor people may consume more of their INCOME than rich people do because they want to reduce the gap in their CONSUMPTION levels. The relative income hypothesis, set out by James Duesenberry, says that a household’s consumption depends partly on its income relative to other families. Contrast with PERMANENT INCOME
Ricardian equivalence
The controversial idea, suggested by David RICARDO, that GOVERNMENT deficits do not affect the overall level of DEMAND in an economy. This is because taxpayers know that any DEFICIT has to be repaid later, and so increase their SAVINGS in anticipation of a tax bill. Thus government attempts to stimulate an economy by increasing PUBLIC SPENDING and/or cutting taxes will be rendered impotent by the private-sector reaction.
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