Question

Suppose residents of Islandia use rubies as money. Every ruby is used, on an average, 7 times per year to carry out transactions. The total supply of rubies is fifty million. (a) What is the level of aggregate nominal spending in Islandia according to the quantity theory of money? (b) Suppose now that the residents of Islandia use less money to conduct the same number of transactions. What is the effect on the velocity of money? (c) Suppose a new financial product named “bonds” introduced into the economy. How the introduction of this new financial product will affect the willingness to hold rubies and consequently the velocity of rubies? (d) Plot the following table on the graph showing average money growth rates on the horizontal axis and average inflation rates on the vertical axis.

Countries	A	B	C	D
Inflation rate	10.88%	5.59%	3.20%	4.36%
Money growth rate	27.92%	34.12%	12.76%	11.44%

(e)Do the data reported in the above table support the quantity theory of money? Explain your answer with the help of the graph you draw in part (d).

Answer 1

As per the quantity of theory of money

M* V = P* Y = Nominal GDP

Where M represents the money supply. Where V represents the velocity of money meaning how many times the money will be spent. P represents the price level . Y represents the real value of goods ( Real GDP).

a. The aggregate Nominal spending is = M* V = 7* 50,000,000 = 350 Million.

b. When the money supply decreases the velocity of money increases i.e. the number of times the money is spent increases.

c. When a new financial product is introduced in the market, the demand for it will be high and this results in low yield on on the financial product. The Price and yield of bonds are inversely proportional, when the demand for the bond increases its price increases and yield decreases and since the yield is less the Companies will have to borrow less to pay for the yields to the bond holders this results in decrease in the supply of money and increase in the velocity of money as a result. When the supply and demand for money is less it results in high velocity of money which gets reflected in increased spending or investments.

d.

e. The data provided does support the quantity theory of money. When the inflation rate rises so will the demand for money and this is reflected in the data as the inflation rate increases the money growth or the money in the economy also increases. When the inflation rate increases so will the demand for money. Because higher prices requires more money for the purchase of goods. When inflation increases so will the cost of holding money so people will either spend or invest when inflation increases instead of holding money. The growth rate of money increases with inflation.