ABSTRACT
This basic framework is called the Quantity Theory of Money. The money supply consists of the bank accounts of households and firms plus the amount of currency in circulation. The velocity of money is the ratio of GDP to the money supply. For example, if the money supply is $4 trillion and the velocity of money is 3, then GDP is $12 trillion. The velocity of money is the number of times the money supply is used to buy final goods and services in a year. Here is the catch. Suppose the money supply falls to $3 trillion and the velocity of money remains 3. Then the GDP will fall to $9 trillion. This decline consists either of a fall in real output or a decline in the price level (or both). On the other side of the coin, so to speak, if the money supply increases to $5 trillion with a constant velocity of money, then GDP increases to $15 trillion – accomplished by an increase in real output or the price level or both. If the economy is at full employment, only the price level increases. As the leading Monetarist Milton Friedman said on occasions too numerous to count, “Inflation is always and everywhere a monetary phenomenon.” The real business cycle group thinks that economic fluctuations are caused primarily by shocks, both negative and positive, to the supply side of the economy. Also, they think that markets adjust quickly so that there is no involuntary unemployment. Workers adjust their work and leisure over time in an optimal manner given the wages and employment opportunities. The Austrians agree that the economy will recover on its own. And they warn against using monetary policy to stimulate the economy by lowering interest rates, thereby (according to them) creating a misallocation of resources in favor of investment that leads to trouble.
