Chapter 20
Quantity Theory, Inflation, and the Demand for Money
Chapter 20 discusses two of the basic building blocks of monetary theory, the quantity theory of
money and the demand for money, examining how these theories can explain inflation in the
long run, This material is more appropriate for a course that emphasizes monetary theory, and
many professors will prefer not to cover it. Later chapters do not depend on this material, so
dropping it from your course will not hinder students’ ability to understand later chapters.
Using the quantity theory, the next section of the chapter discusses how budget deficits can lead
to inflation. Students find this discussion particularly interesting because of the current debates in
Congress on reigning in budget deficits. The key to getting students to understand why budget
deficits matter to inflation is to emphasize the government budget constraint in Equation 7. The
application on the Zimbabwean hyperinflation is fun to discuss in class, not only because it
illustrates how budget deficits lead to high inflation but also because Robert Mugabe is famous
for destroying his country and hyperinflation is one manifestation of his disastrous policies.
The chapter ends with a discussion of the current state of empirical evidence on the demand for
money, and it focuses on two basic questions that are central in monetary theory: (1) How
sensitive is the demand for money to changes in interest rates? and (2) Is the demand for money
function stable over time? The discussion here is nontechnical but should give the student a feel
for how empirical research in economics is done. A far more extensive discussion of the
empirical evidence can be found in an appendix to this chapter in MyLab Economics. If students
in the course have some training in regression analysis, a professor may want to spend more time
on the empirical work on money demand. An excellent supplementary reading in this case is
Goldfeld’s article, “The Demand for Money Revisited,” listed in the footnotes in the appendix.
This article is very clearly written and demonstrates how high-quality empirical work should be
done.