Question

Suppose that changes in bank regulations expand the availability of credit cards, so people need to hold less cash.

a. How does this event affect the demand for money?

b. How does this event affect the money velocity?

c. If the Fed does not respond to this event, what will happen to the price level?

d. If the Fed wants to keep the price level stable, what should it do?

Answer 1

Ans.

a) The money demand will fall because credit card is like an interest free loan for a particular period, so, people would prefer to hold less currency decreasing demand for money.

b) Now, because cards are being used for transaction, so,velocity of money will increase as demand for money is less but transaction have not decreased.

c) If FED does not respond to increase in velocity of money, it will lead to decrease in interest rate in the economy due to excess supply of money inducing investment and consumption which will increase aggregate demand increasing price level and output. In long run, output will move back to full employment level but price level will increase further. So, there will be an increase in inflation.

d) FED need to reduce the money supply which will offset the effect of decrease in money demand’s effect on interest rate. Thus, keeping inflation rate stable. This can also be seen from equation of quantity of money,

Nominal Money supply*Velocity of money = Price level* Real output

So, increase in velocity will require decrease in nominal money supply otherwise at given level of real output, price will increase by same percentage as velocity of money.

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