CHAPTER 7
Rate of Return and Interest Rate
The Role of Interest Rate
One of the main shortcomings of the classical quantity theory is that it does not address the fact that the demand for money is affected by the interest rate. Recall from Chapter 1 that the equation of exchange is
MV = PQ(7.1)
According to the equation of exchange, the amount of money in the economy times its velocity equals the overall expenditures on all traded goods and services. This equation represents an inevitable reality and is, in fact, an identity, not an equation. An increase in economic activity—the right-hand side of the identity—would and should, inevitably, result in an equal increase on the left-hand side of the identity. Perhaps the biggest shortcoming of the ...
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