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http://data.worldbank.org/country/india 

     

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)?