Question

As you know the corona vires has cause a massive decline (shift to the left) in the aggregate demand curve. Remember that the GDP is equal to consumption (C), gross investment (I), government expenditures (G) and net exports (Imports minus Exports or E_x) and this spending GDP is equal to the Price times the Quantity of all final goods and services (P * Q = Y) and also equal to the money supply times the velocity of circulation (M * V = Y). So the full formula is listed below:

             aggregate demand                                             money and spending

                C   +   I   +   G   +   E_x                   =                    P * Q = M * V

According to the text per chapter 15 the main argument between the Monetarist and the Keynesians is the velocity of money (V). Is it stable or unstable. Three questions for you to answer:

1. The Federal Reserve Bank has been increasing (decreasing) the money supply. Why?

2. If as the Monetarist believe, V is stable, what would happen to prices (P)?

3. Since the consumer price index (CPI) has fallen over the last two months, what must have happened to aggregate demand or Q?

Answer 1

Answer 1:

The Federal Reserve has been increasing the level of money supply in the economy in the times of current pandemic because increase in the level of money supply helps in the reduction of the rate of interest in the money market which inturn increases the level of planned investment in the economy. Increase in the level of planned investment increases the level of aggregate demand in the economy and this increase in aggregate demand in turn increases the level of national output or production or national income in the economy eliminating recessionary gap in the economy caused by the pandemic.

Answer 2:

If monetarist belive that V is stable then increase in the level of money supply in the economy will lead to increase in price level in the economy given direct relationship between price and quantity of money as depicted by the Quantity Theory of Money.

Answer 3:

A decline in the level of CPI means that aggregate demand or Q must have fallen in the economy because decline in the level of Q or aggregate demand leads to fall in demand and this reduces price level in the economy.