The equation of exchange is an identity that relates the money supply, velocity,

Question

The equation of exchange is an identity that relates the money supply, velocity, the price level, and real output. An identity is something that is true by definition.

One group of economists, the monetarists, look at the equation of exchange and say that the Fed should simply increase the money supply by an annual rate equal to the long-run growth rate of the economy. Explain the effect that such a policy is likely to have on inflation. (5 points)

Another group of economists, those who hold to the quantity theory of money, believe that V is predictable and otherwise unchangeable and that Q is steady. Is their view of the economy consistent with the Keynesian view, the classical view, or neither? Explain. (5 points)

Explanation / Answer

1. Monetarists have argued that the increase in money supply will have no impact on the real variables like output, employment, rate of interest in the long run and only impact Price level in the economy but have come to the conclusion that in the short run money will impact the real variables in the economy. They also stated that during the yeas of Great Depression 1929 -33, Fed reduced the amount of money supply in the US economy by a drastic amount which is also one of the explanation of the Great Depression.

2. This group believes that the increase in the money supply will lead to proportionate increase in the price level both in the short run and long run and no impact on the real variables. Thus, is in contrast with the Keynesian view who viewed money supply as an important determinant of the interest rates and thus aggregate demand in the economy. This group in consistent with the classical view who believe in classical dichotomy or money only influencing nominal variables and real variables.

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