Question

Draw graphs using appropriate units and label them. Graphs without labels WILL NOT BE given any points even if the answer is correct. Explain clearly wherever asked.

1. Exercise on quantity equation and AD curve

1. Assume money supply is fixed at M=1000 and the velocity of money V=2.0, complete the table 1

M	V	PY	P	Y
1000	2.0		2.0
1000	2.0		1.5
1000	2.0			2000
1000	2.0		0.8
1000	2.0			4000

2. Draw the AD curve that results from the table results and label as AD₁

c. What does the AD curve denote?

   d. Suppose the money supply increases to 1500 while velocity remains equal to 2.0, complete the table 2 below (use the price level from the previous table 1)

M	V	P	Y
1500	2.0
1500	2.0
1500	2.0
1500	2.0
1500	2.0

   e. Plot the AD curve with the data from Table 2 and label the curve as AD₂ (when M=1500 and V=2.0)

f. Suppose if the money supply remained at its original level of 1000 but the velocity increases to 3.0, how does it affect the AD curve?

   g. Suppose if the money supply fell to 500 while velocity remained equal to 2.0, complete the following table 3

M	V	P	Y
500	2.0
500	2.0
500	2.0
500	2.0
500	2.0

   h. Plot the AD curve with data from Table 3 and label the curve as AD₃ (when M=500 and V=2.0)

   I. Plot the AD curve with data from Table 3 and label the curve as AD₃ (when M=500 and V=2.0)

Answer 1

Before answering the questions, let us discuss about the quantity equation.

If, the Money Supply in the economy is M, the Velocity of Money is V, the Aggrigate Price level is P and Aggrigate Output is Y, then the quantity equation says

M.V = P.Y........(1)

Now, in the following questions, we are given fixed values of M and V. And, some values of P and some values of Y are given.

When, M, V and P are given, from (1) we get,

Y = M.V/P........(2)

And, when, M, V and Y are given, from (1) we get,

P = M.V/Y........(3)

(a) In the given economy, the Money Supply (M) is fixed at M=1000 and Velocity of Money is V=2.0.

Now, we will fillup the table 1.

M	V	PY(=MV)	P(=M.V/Y)	Y(=M.V/P)
1000	2.0	2000	2.0	1000
1000	2.0	2000	1.5	1333.33
1000	2.0	2000	1	2000
1000	2.0	2000	0.8	2500
1000	2.0	2000	0.5	4000

(b) Now, we will draw the Aggrigate Demand or AD curve with the values of Price (P) and Output (Y) from the table above. The equation of the AD1 is

P = 2000/Y

The AD curve is labelled as AD1.

(c) The AD curve denotes the aggrigate level of output produced in the economy at different level of prices. Here we can clearly see from the table that, when the aggrigate level of price falls, the aggrigate demand increases gradually.

(d) Now, suppose money supply increases to 1500 and velocity remains constant at 2.0. Hence, we have to complete the table 2 below (use the price level from the previous table 1).

M	V	P.Y(=M.V)	P(from table 1)	Y(=3000/P)
1500	2.0	3000	2.0	1500
1500	2.0	3000	1.5	2000
1500	2.0	3000	1	3000
1500	2.0	3000	0.8	3750
1500	2.0	3000	0.5	6000

(e) Now, we will plot the AD curve with the values of P and Y from table 2. The equation of AD2 is

P = 3000/Y

The AD curve is labelled as AD2.

(f) Now suppose the money supply (M) remained at its original level of 1000 but the velocity (V) increases to 3.0.

From the quantity equation we can see that

M.V = 1000×3 = PY

or, MV = PY = 3000

Hence, this is the same situation as table 2. For different values of P, we will get the same values of Y astable 2, because the equation of AD curve is unchanged i.e.

Y = 3000/P

Hence, the AD curve will not be affected.

Hence, if money supply remains 1000 but velocity increases to 3.0, it does not affect the AD curve.

(g) Now suppose the money supply fell to 500 while velocity remained equal to 2.0.

Let us fillup the following table 3.

M	V	PY	P	Y(=1000/P)
500	2.0	1000	2	500
500	2.0	1000	1.5	666.67
500	2.0	1000	1	1000
500	2.0	1000	0.8	1250
500	2.0	1000	0.5	2000

(h) Now, we plot the AD curve with the help of the values of P and Y from the above table 3. The equation of AD3 is

P = 1000/Y

Question no. (i) is same as Question no. (h)

Hope the solutions are clear to you my friend.