IZA DP No. 8399: Deriving the New Quantity Equation: An Approach for a Closed and an Open Economy
This theoretical contribution shows a simple way in which the quantity equation can be derived as a long-term equilibrium solution for the case of a closed economy and an open economy, respectively. It is shown first for the case of a closed economy which parameters stand behind "velocity" and that indeed there are arguments why velocity should be constant over time – assuming a specific parameter set of the goods market. It is noteworthy that the quantity equation can be derived both in a demand-side context and in a long run supply-side approach. Moreover, a new derivation is presented for the case of an open economy and it is shown that trade as well as foreign direct investment should be expected to have an influence on the price level and the inflation rate, respectively. Finally, the analysis suggests that financial market activities should have an impact on the price level.