Question

(3) The money supply is fixed at $60billion and the equilibrium value of money 1/P = 1/2. The Federal Reserve increases the money supply by $20 billion and as a result the new equilibrium price level is 5. Use the Money Supply-Demand Model (Diagram) to explain clearly how equilibrium is restored in the model. If money supply increases the value of money will not increase but will go down.

Answer 1

3. The quantity of money and price are directly related to each other. But the value of money Shows an inverse proportionate retaionship with money supply. In the fisher's equation of exchange

MV =PT

M stands for total quantity of money, V velocity of circulation of money P is price level and T is total volume of transactions. Here we assume that V and T are constant then M=P.which means there is a direct proportionate relationship between M and P. value of money is the reciprocal ie

V =1/P

Now come to the answer, here money supply is fixed at 60 billion US dollar. And the equilibrium value of money is 1/2. Then federal reserve increase its money supply by 20 billion. New equilibrium price 5 is established. This can be explained with the help of the following diagram

In the above diagram , nominal stock of money is measured along the horizontal axis and the value of money on the vertical axis. Money supply is fixed. So that MS is a straight line parallel to Y axis. And MD is a downward sloping . MS=MD at A where equilibrium point is established. Value of money is 1/2 at that point. Federal Reserve increase their money supply so that MS0 shifts to MS1. a new equilibrium point is established at B. Here equilibrium price is 5. Which means if money supply increases price also increases and vice-versa. Another important thing is that value of money will come down because it is the reciprocal of money supply ( V=1/P).