Question

1. Using the aggregate demand (AD), the short-run aggregate supply (SRAS), and the long-run aggregate supply (LRAS) curves, briefly explain how an open market purchase will affect the equilibrium price level (P) and real output (Y) in the short run. Assume the economy is initially in a recession.

2. Using the quantity equation (the equation of exchange) briefly explain the quantity theory of money. Specifically, how the quantity theory of money explains why inflation occurs.

Answer 1

Qn. 2

The quantity theory of money was first propounded by Irving Fisher in 1911. Fisher's version is also termed as 'Equation of Exchange'

The quantity theory of money states that there is a direct relationship between the quantity of money in an economy and the level of prices of goods and services sold.

In its simplest form, the theory is expressed as:

MV = PT

Each variable denotes the following:
M = Money Supply
V = Velocity of Circulation (the number of times money changes hands)
P = Average Price Level
T = Volume of Transactions of Goods and Services

Explanation:

1. There is strong relationship between Money and Price Level. So, Quantity of Money is the main determinant of the Price Level or the Value of Money

2. Changes in the General Level of Commodity Prices/Values/Purchasing Power of Money are determined by changes in the Quantity of Money in circulation

3. Higher the number of transations that people want, higher will be the demand for money (Transactions Motive)

Why Inflation Occurs?

1. According to QTM, if the amount of money in an economy doubles, price levels also double, causing inflation (the percentage rate at which the level of prices is rising in an economy). The consumer, therefore, pays twice as much for the same amount of the good or service.

2. Money is like any other commodity: increases in its supply decrease marginal value (the buying capacity of one unit of currency). So an increase in money supply causes prices to rise (inflation) as they compensate for the decrease in money's marginal value.