Question

24. 2) According to the quantity theory of money, how would a decrease in velocity affect AD?

If output is below the natural rate, explain why it would automatically fall through changes in the labor market.

Answer 1

Answer:

Quatity theory of money:

The quantity theory of money is a theory that variations in price relate to variations in the money supply. The most common version, sometimes called the "neo-quantity theory" or Fisherian theory, suggests there is a mechanical and fixed proportional relationship between changes in the money supply and the general price level. This popular, albeit controversial, formulation of the quantity theory of money is based upon an equation by American economist Irving Fisher.

An exogenous decrease in the velocity of money causes the aggregate demand curve to shift downward. In the short run, prices are fixed, so output falls.

If the Fed wants to keep output and employment at their natural-rate levels, it must increase aggregate demand to offset the decrease in velocity. By increasing the money supply, the Fed can shift the aggregate demand curve upward, restoring the economy to its original equilibrium at point . Both the price level and output remain constant If the Fed wants to keep prices stable, then it wants to avoid the long-run adjustment to a lower price level at point  in the figure above. Therefore, it should increase the money supply and shift the aggregate demand curve upward, again restoring the original equilibrium at point Thus, both Feds make the same choice of policy in response to this demand shock.

The nayural rate of unemployment:

Economists often talk about the "natural rate of unemployment" when describing the health of an economy, and specifically, economists compare the actual unemployment rate to the natural rate of unemployment to determine how policies, practices, and other variables are affecting these rates.

If the actual rate is higher than the natural rate, the economy is in a slump (more technically known as a recession), and if the actual rate is lower than the natural rate then inflation is expected to be right around the corner (because the economy is thought to be overheating).