Question

According to the quantity theory of money, an increase in the money supply only raises the
price level in the long run. This is because

A. the long-run aggregate supply is unaffected by the money supply, while the aggregate
demand increases when the money supply increases.

B. the long-run aggregate supply is lower when the money supply increases, while the aggregate demand is unaffected by the money supply.

C. the short-run aggregate supply and the aggregate demand both increase.

D. the effects of an increase in the money supply on the long-run aggregate supply and on
the aggregate demand cancel out.

Answer 1

Answer: A. The long-run aggregate supply is unaffected by the money supply, while the aggregate
demand increases when the money supply increases.

We can write the equation of the quantity theory of money as;

MV = PY

Where M = money supply;

V = velocity of money, i.e., the times a single currency has circulated or has changed the hands in an economy;

P = price of goods and services;

Y = real output.

According to the quantity theory of money, the price increases at the same proportion of the increase of money supply. Now if 'V' , and 'Y' remain constant, the increase in money supply in long-run will increase the aggregate demand in the economy. As the output remains constant, the increase in aggregate demand causes an excess demand in the economy. This excess demand creates an upward pressure of the general price level in the economy. As a result, the price level rises in the long-run.

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