Suppose that the money supply is $95 billion and the nominal GDP for our model e
ID: 1196336 • Letter: S
Question
Suppose that the money supply is $95 billion and the nominal GDP for our model economy is $340 billion. What is the equation of exchange? What is the formula and the definition of the velocity of money? How will households and businesses react if the Federal Reserve reduces the money supply by $20 billion? (To answer this question completely you need to find the new velocity of money) Using the equation of exchange, by how much will nominal GDP have to fall to restore equilibrium, according to the monetarist perspective?Explanation / Answer
a). Equation of exchange: MV=nominal GDP
where, M = money supply and V = velocity
So, 95 x V = 340
V = 340/95 = 3.58
b). Velocity is the number of times the average dollar is spent to buy final goods and services in a given year.
Velocity can be calculated by using V = (P x Y ) / M
The equation tells us that total spending (M x V) is equal to total sales revenue (P x Y). Since (P x Y) is equal to the nominal GDP, then M x V = nominal GDP.
(where, P = the price level, and Y = real output, or real GDP.
c). If money supply is reduced by $20 billion, then the new money supply is $75 billion.
New velocity of money is
75 x V = 340
V = 340/75 = 4.53
The households and businesses will reduce spending.
d). Given the reduction in the money supply by $20 billion households and businesses will reduce spending for a given velocity of money.
The new money supply is $75 billion Given the velocity of money, this implies MV = $75x3.58 = $268.5 billion.
From the equation of exchange MV = $268.5 billion, thus nominal GDP must fall by $71.5 billion (= $340 - $268.5).
Therefore, the conclusion is: The households and businesses will reduce spending and GDP will have to fall by $71.5.
Related Questions
drjack9650@gmail.com
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.