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 this same economy government fixes the nominal money supply at 5000. With output fixed at its full-employment level and with the 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

(a)
I. 4,000
II. 2,000
(b)
I. 2.5
II. 3

WORKING:

The important equation to know is:
MV = PY

M = Money supply
V = 5 = Velocity
P = 2 = Price level
Y = 10,000 = GDP

So to work out M we just substitue in:
M*(5) = (2)*(10,000)
M = (20,000)/5
M = 4,000

Assuming we are at equilibrium, demand = supply so nomicla money demand is 4,000. Then we divide by 2 (the price level) to get real money demand (that's 2,000)

Now we have new variables (with price being our dependant variable).
M = 5,000
V = 5
Y = 10,000

So now we solve for P:
(5,000)*(5) = (10,000)*P
P = (25,000)/(10,000)
P = 2.5

If M = 6,000:
(6,000)*(5) = (10,000)*P
P = (30,000)/(10,000)
P = 3

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