Question

1. An economy begins in long-run equilibrium, and then a change in government regulations makes holding and using credit cards more desirable.  

1. How does this change affect the demand for money?

2. What happens to the velocity of money?

3. If the Fed keeps the money supply constant, what will happen to output and prices in the short run and in the long run?

4. If the goal of the Fed is to stabilize the price level, should the Fed keep the money supply constant in response to this regulatory change? If not, what should it do? Why?

Answer 1

The demand for money and the velocity of money are inversely related. An increased money supply will lower money velocity, all else being equal. Money velocity increases when money is spent more frequently for final goods and services per unit.

An economy work best when inflation is low and predictable. Over long run, inflation is largely determined by how much the money supply increases in real GDP. In short run inflation also depends on the velocity of money which inversely depends on the demand for money.

Ø The demand for money will rise holding money is more attractive.

Ø People hold more money and the circulation of notes is less, velocity will decrease.

Ø If the money supply is constant demand curve will be downward because of decrease in velocity. Price will be sticky in the short run and the economy move from current equilibrium to new short term equilibrium.

Ø FED has an option to increase money supply to cancel out decrease in velocity it could return economy to its starting equilibrium. It has an option to make change in money demand also. So new policy doesn’t create problems.