Question

a) Write out the equation that describes the Quantity Theory of Money. Must indicate clearly what each variable in the equation means in order to earn full marks .
Based on the equation, predict what would happen to inflation in the long run:

b). if the growth rate of the velocity of money is zero and money supply grows at a faster rate than real GDP growth rate. You may use some hypothetical numbers to illustrate your answer (1.5 marks)
c). if the growth rate of the velocity of money is zero and money supply grows at a slower rate than real GDP growth rate. Use some hypothetical numbers to show (1.5 marks)
d). Based on these two scenarios (b and c) and the quantity theory of money as stated in this question, what would be a good monetary policy for the economy in the long run?

Answer 1

QUANTITY THEORY OF MONEY

• It states the relationship between the quantity of money and the level of price.
• When money supply increases, price level also increases.

(A) MV = PT

Where M = money supply

V = velocity of circulation

P = average price level

T = volume of transcations of goods and services

(B) It is given that money supply is greater than the real GDP (output), creating a situation of inflation. Therefore

P = MV / T

P = $1000 *0 / $ 100 (V=0; given in the question) [ M= $1000 bn & $100bn]

P = 0

From the above we can say that, the problem of inflation is cured in the longrun.

(C) It is given that the money supply is less than the output. Now there is deflation

P = MV / T

P = $500 *0 / $1000 (V=0; given in question) [ M = $500 & $ $1000]

P = 0

From the above we can say that the deflation is wiped away in the long run

(D) During inflation government imposes more taxes to reduce money supply and during deflation government increases its spending in order to increase the supply of money in the economy. This cycle is repeated and finally the economy reaches equillibrium in the long run.