According to the quantity equation, changes in the money supply will lead directly to changes in...

According to the quantity equation, changes in the money supply will lead directly to changes in the price level if velocity and real GDP are unaffected by the change in the money supply. Will velocity change over time? What factors might lead to changes in velocity? Are those changes related to changes in the money supply?

Expert Solution

According to quantity theory of money, there is a direct relationship between money supply and price level. If the money supply in an economy doubles price level also double. Increase in money supply decreases marginal value (the buying capacity of one unit of currency). Thus it causes prices to rise (inflation) as they compensate for the decrease in money's marginal value.The theory is expressed as

MV = PT

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

The theory assumes that Velocity of Circulation (V) and Volume of Transactions (T) are constant in the short term. The assumption that V is constant has been criticised and the argument points out that the velocity of circulation depends on consumer and business spending impulses, which cannot be constant. So, the Velocity will change over time.

The theory also assumes that the quantity of money, which is determined by outside forces, is the main influence of economic activity in a society. A change in money supply results in changes in price level or a change in supply of goods and services.These changes in money stock causes a change in spending. And the Velocity of Circulation depends not on the amount of money available or on the current price level but on changes in price levels.

Velocity could change in response to changes in money supply. Increases in money supply lead to a decrease in the Velocity of Circulation and that Real Income, the flow of money to the factors of production increased.

Rahul Sunny answered 2 years ago

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