Question

answer the following conceptual questions

1.)Assuming the central bank responds to the decrease in velocity by increasing the money supply, describe the effects of this policy in the short and long run.

2.) Assuming alternatively the central bank does nothing to address the decrease in velocity, describe the effects of this policy in the short and long run.

Answer 1

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Question:

Answer:

1). Answer:

As per the question, the central bank responds to the decrease in velocity by increasing the money supply. Normally when central bank increasing the money supply then interest rate falling down and demand of money increase that increase the aggregate demand in the economy. increasing  aggregate demand increase the price level and GDP. But, when, the economy is in a deep recession of falling down sharply then its decrease the consumer confidence. Because of lower consumer confide people don't spend more so, increasing money supply not more effective or not effective also.

Velocity od Money = P*Q/M

Where,

P = price

Q = Quantity of goods and services

M = money supply.

PQ = Nominal GDP

So, V = Nominal GDP/M

Nominal GDP = V * M

V*M = P*Q

So, if the central bank responds to the decrease in velocity by increasing the money supply. In short run it will control the inflation level but in long run it will reduce the growth rate. Because Velocity of transaction decrease and supply of money increase that means at the lower cost of money (when money supply increase then cost of money/interest rate decrease) people are not spending more so, it will not increase aggregate demand in the economy and in long run it will negatively affect the growth rate.

2). Answer:

If  the central bank does nothing to address the decrease in velocity and increase supply of money then in short run it will increase GDP and price level(inflation) but in long run it will only increase price level. Because when the central bank increase money supply then interest rate decrease and people demanding for more money and spend it that increase the aggregate demand in the economy that increase the price level and growth rate. But in long run only price level will increase.

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