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 the 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

As per quantity equation,

Money supply (M) x Velocity (V) = Price level (P) x Real output (Y) [So (P x Y) = Nominal output]

(a)

M x 5 = 10,000 x 2

5M = 20,000

M = 4,000 (Nominal money supply)

Real money supply = Nominal money supply / Price level = 4,000 / 2 = 2,000

(b)

(i) When nominal money supply = 5,000

5,000 x 5 = P x 10,000

25,000 = 10,000P

P = 25,000/10,000 = 2.5

(ii) When nominal money supply = 6,000

6,000 x 5 = P x 10,000

30,000 = 10,000P

P = 30,000/10,000 = 3

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