Question

Which of the following statements is consistent with the quantity theory of money?

• Monetary policy should be used in the short run to try to steer the economy.

• The money supply should be increased by a percentage to allow for changes in productivity and growth, but that percentage cannot be determined.

• Expansionary monetary policy is the only way to prevent a mild recession from developing into a serious recession or depression.

• A prescribed monetary policy should be followed regardless of what's happening in the economy.

Answer 1

Which of the following statements is consistent with the quantity theory of money?

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Correct Choice:

A prescribed monetary policy should be followed regardless of what's happening in the economy.

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Explanation:

The quantity theory of money is a classical theory. It explains long term behavior, and is often considered incapable of explaining short term behavior. It takes the velocity of money and real GDP as constant. Thus, the main variables are money supply and price level. Further, changes in MS affect prices directly. Thus, it says that a targeted level of inflation should be maintained by regulating money supply accordingly. All other issues pertaining to velocity of money, productivity and short term changes, are not covered in the theory. Monetary policy is prescribed as per the target inflation rate.

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Reasons for other options being incorrect:

The theory is more about long run behavior, thus it may not predict short run changes accurately. Further, it doesn't link money supply to productivity and growth, but only prices. Further, it also doesn't talk about business cycles, since it assumes full employment.