The Classical Theory of

Inflation

To explain the long run determinants of the price level and the inflation rate.

The Level of Prices and

the Value of Money

When the overall price level rises, the value of money falls.

Money Supply, Money

Demand, and Monetary
Equilibrium

Money Supply Money Demand

RBI, together with the banking system, The demand for money reflects how much
determines the supply of money (OMO). wealth people want to hold in liquid form.
 The Effects of a
Monetary Injection

Quantity Theory of
Money

A theory asserting that the quantity of money available determines the price level
and that the growth rate in the quantity of money available determines the inflation rate

The Classical Dichotomy

and Monetary Neutrality

Classical Dichotomy
The theoretical separation of nominal and real variables

Nominal Variables Real Variables

Variables measured in monetary units Variables measured in physical units
 Monetary Neutrality

The proposition that changes in the money supply do not affect real variables

Velocity and the

Quantity Equation

Velocity of Money

The rate at which money changes hands

To calculate the velocity of money, we divide the nominal value of output (nominal GDP) by the
quantity of money

Quantity Equation

The Inflation Tax

The revenue the government raises by creating money

The Fisher Effect

This adjustment of the nominal interest rate to the inflation rate is called the Fisher effect