Question

If velocity ​(V) and aggregate output ​(Y) remain constant at

​$5

and

​$1,250

billion​,

​respectively, what happens to the price level ​(P) if the money supply​ (M) declines from

​$425

billion to

​$325

​billion?

​Originally, the price level is

nothing.

​(Round

your response to two decimal​ places.)

After the money supply​ decreases, the price level is

Answer 1

Answer

The equation of the quantity theory of money is as follows,

MV = PY...........(1)

Where, M = Money supply in an economy

V = Velocity of money

P = Price level

Y = Aggregate output or real GDP

Here, it is said that the velocity ​(V) and aggregate output ​(Y) remain constant . Now if the money supply declines, the left hand side of the quantity theory of money equation, i.e., MV, will decrease. So, we conclude that the price level must decrease in the economy. In the quantity theory of money, the money supply and price move in same direction.

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Here, initially, money supply(M) is $425 billion, velocity(V) is 5, GDP(Y) is 1250

Now, putting the values in equation(1), we get,

$425 * 5 = P * 1250

Or, $2125 = 1250 * P

Or, P = $2125 / 1250

Or, P = $1.7

Originally the price level is $1.70.

Later the money supply falls to $325 ​billion, velocity remains constant at 5, GDP(Y) also remains constant at 1250.

Putting the values in equation(1), we get,

$325 * 5 = P * 1250

Or, $1625 = 1250 * P

Or, P = $1625 / 1250

Or, P = $1.3

So, after the money supply​ decreases, the price level is $1.30.

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