(Quantity Theory of Money) What basic assumption about the velocity of money tra
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Question
(Quantity Theory of Money) What basic assumption about the velocity of money transforms the equation of exchange into the quantity theory of money? Also:
1.According to the quantity theory, what will happen to nominal GDP if the money supply increases by 5 percent and velocity does not change?
2.What will happen to nominal GDP if, instead, the money supply decreases by 8 percent and velocity does not change?
3.What will happen to nominal GDP if, instead, the money supply increases by 5 percent and velocity decreases by 5 percent?
4.What happens to the price level in the short run in each of these three situations?
Explanation / Answer
Based on Fisher equation,
MV = PT
M is the stock of money,
V is the Velocity of circulation,
P is the average price level,
T is the number of transactions in the economy
The equation states that the quantity of money spent equals the quantity of money used. The theory says that the quantity of Money available in an economy determines the value of money. Increases in the Money supply are the main cause of Inflation.
What basic assumption about the velocity of money transforms the equation of exchange into the quantity theory of money?
The quantity theory assumes that Velocity and No. of Transactions are both constant, at least in the short-run.
According to the quantity theory, what will happen to nominal income if the money supply increases by 5 percent and velocity does not change?
Any change in Money supply leads directly to a change in Price. In other words, increase the money supply and you simply cause inflation. It will lead to increase in Nominal Income and Price levels by 5%
What will happen to nominal income if, instead, the money supply decreases by 8 percent and
velocity does not change?
It will lead to decrease in Nominal Income and Price levels by 8%
What will happen to nominal income if, instead, the money supply increases by 5 percent and velocity decreases by 5 percent?
If the amount of money in circulation doubles, the quantity theory predicts that, once in equilibrium, the price level will also double (or close to it), and that if the amount of money in circulation is cut in half, the price level will be (about) one half its former value after all adjustments have taken place. Here the increase in money supply will be neutralised by decrease in velocity.There will be no effect on Price levels and Nominal Income.
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