KEY EQUATIONS
According to the money demand function, the real quantity of money demanded, Md/P, depends on output and the nominal interest rate on alternative, nonmonetary assets.
An increase in output, Y, raises the number of transactions people make and thus raises the demand for money. An increase in the nominal interest rate on nonmonetary assets, i (which equals the expected real interest rate, r, plus the expected rate of inflation, πe) raises the attractiveness of alternative assets and thus reduces the demand for money.
Velocity, V, is nominal GDP, or P times Y, divided by the nominal money stock, M. Velocity is assumed to be constant by the quantity theory of money.
The asset market equilibrium condition states that the real supply of money, M/P, and the real demand for money, L (Y, r + πe), are equal.
The inflation rate, π, equals the growth rate of the nominal money supply, ∆M∕M, minus the growth rate of real money demand. In long-run equilibrium with a constant nominal interest rate, the growth rate of real money demand equals the income elasticity of money demand, ηy, times the growth rate of real income or output, ∆ Y/Y.
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