Econ 205 Professor Joel David Fall 2013

Homework 5

The Quantity Theory of Money In this exercise, you will obtain and summarize data on money supply and growth, and inflation for a particular country and check some of the predictions of the quantity theory of money. We will again use data from the World Bank World Development Indicators database (refer to HW2 for instructions on how to access these data).

1. Download two data series for your country for all available years: (1) money and quasi money (M2) (current LCU), and (2) Consumer Price Index. The first of these will be our measure of the money supply and the second of the aggregate price level.

2. What year serves as the base year for the CPI? Create an analogous index of the money supply as follows: in each year, divide the value of the money supply by its value in the year that serves as base year for the CPI and multiply the result by 100. Both series should then have a value of 100 in the base year.

3. Create a graph comparing the path of prices and the money supply over time. The graph should show the CPI and the money supply index you created. The x-axis should show years and the y-axis index values.

4. The quantity theory predicts that prices and money supply move together. Does this seem to be true over the entire time period? What is the correlation between the two? Is it high or low? (a value close to or below zero is low, a value close to one is high).

5. Now, compute annual growth rates in the money supply and the price level. To do this, calculate percentage changes in each series in each year (the percentage change in the CPI is of course our measure of inflation).

6. Create a graph similar to that in part 3 comparing the annual growth rates of prices and money.

7. The quantity theory predicts that prices and money supply move together. Does this seem to be true when looking at year-to-year changes? What is the correlation between the two? Is it high or low?

8. We have said that the quantity theory is a good description of the relationship between money and prices in the long run, but perhaps not in the short run. Do your findings support this argument? Why (or why not)?