37. According to the quantity theory of money, what is the effect of an increase

Question

37. According to the quantity theory of money, what is the effect of an increase in the quantity of money? 38. Explain the difference between nominal and real variables, and give two examples of each. According to the principle of monetary neutrality, which variables are affected by changes in the quantity of money? In what sense is inflation like a tax? How does thinking about inflation as a tax help explain hyperinflation? 39. According to the Fisher effect, how does an increase in the inflation rate affect the real interest rate and the nominal interest rate? 40. What are the costs of inflation? Which of these costs do you think are most important for the Canadian economy? 41.

Explanation / Answer

37. Classical quantity theory of money explains relationship between quantity of money and general price level. According to it, there is direct and proportionate relationship between quantity of money and general price level. The basic equation of quantity of money is expressed by equation of exchange:

MV = PY

where M is the quantity of money

V is the transaction velocity

P is the price level

Y is the real GDP

According to Classical Quantity Theory of Money, output is constant at full employment level because labor market is always in equilibrium.

P = (V/Y) x M

According to this equation, quantity of money determines price level. A doubling of M doubles P or a 10% increase in M leads to a 10% increase in P.

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