1. What is the equation of exchange? What are the variables, which are in it, an
ID: 1110570 • Letter: 1
Question
1. What is the equation of exchange? What are the variables, which are in it, and how do they relate to each other? 2. You have the assignment of making a recommendation to the Chairperson of the Fed during a period of persistent, high inflation. What recommendations would you give to deal with the high inflation rate? 3. Explain how interest rates and the price level can affect the demand for money. 4. Explain how monetary policy can be used to close the (a) contractionary gap and (b) inflationary gap
Explanation / Answer
Answer
(1) equation of exchange represent the relationship between the money supply , velocity of money , total economic transaction in the economy and price level. Equation can be written as follows:
= M* V = T*P
M represents the supply of money
V represents the velocity of money
T= total no of transaction or index of expenditures
P = represents the price level in the economy
(2) during the period of high inflation I would recommend to use the contraction monetary policy in which increase the bank rate, increase the reserve requirement , OMO ( selling the security and credit rationing) all these measures will decrease the money supply in the economy as the rise in interest rate will decrease the loan requirement taking by both firms and household, it would also bound the bank to give more loan to market , by selling the government securities they would decrease the liquidity from the market. and credit rationing lead to systematic distribution of money to needed area only, all these measures will control he inflation situation in the economy
(3) there is inverse relationship between the interest rate and demand for money as rise in interest rate will decrease the demand for money and vice versa and opposite to it increase in price level increase the demand for money as increase tin price decrease the purchasing power of money which can not used to purchase more product so demand for money increases.
(4) during the contraction gap, FED uses expansion monetary policy by decreasing the bank rate, OMO , purchasing securities form market, decreasing the reserve requirement and decrease the reverse repo rate , all these will increase the money supply in the market and aggregate demand would increase to potential aggregate demand would fulfill the gap existing .
And opposite to it in inflationary gap FED uses the strict monetary policy, in which he would increase the bank rate, OMO ( selling the securities in the open market ), increase the reserve requirement, increase the reverse repo rate, all these measure decrease the money supply and this would lead to decrease in aggregate demand and reduce the inflation gap.s
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