Assume that the quantity theory of money holds and that velocity is constant at

Question

Assume that the quantity theory of money holds and that velocity is constant at 5. Output is

fixed at its full-employment value of 10,000, and the price level is 2.

a. Determine the real demand for money and the nominal demand for money.

b. In the same economy the government fixes the nominal money supply at 5000. With output

fixed at its full-employment level and with assumption that prices are flexible, what will be

the new price level? What happens to the price level if the nominal money supply rises to

6000?

Explanation / Answer

The quantity theory of money states that (Prices x Output = Nominal money supply x Velocity). Velocity is a measure of how hard money 'works' (the amount of purchases a single dollar facilitates).

a) PY=MV
2*10,000=M*5
4,000 = M (the nominal money supply/demand)

Real demand for money is defined as (Nominal Demand/Price Level). M/P = 4,000/2 = 2,000

b) i) Y=10,000 (fixed output)
M= 5,000 (fixed nominal money supply)
V=5 (constant)

P=MV/Y
P=5,000*5/10,000
P=2.5 (The price level when nominal money supply is held constant at 5,000 is 2.5)

ii) M=6,000

P=6,000*5/1,000
P=3 (When the nominal money supply rises to 6,000 the price level increases to 3,ceteris paribus).

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