Chapter 14: Problem 6

In monetarism, how will each of the following affect the price level in the short run? a. An increase in velocity b. A decrease in velocity c. An increase in the money supply d. A decrease in the money supply

Short Answer

Expert verified

In the short run, an increase in velocity or money supply will raise the price level. Conversely, a decrease in velocity or money supply will decrease the price level.

Step by step solution

Understanding the Variables in the Quantity Theory of Money Equation

The first and crucial step is to know and have a clear understanding of the variables M (money supply), V (velocity of money), P (price level), and Y (real GDP) in the equation MV = PY.

Effect of an Increase in Velocity on the Price Level

If velocity (V) increases, assuming the money supply (M) and real GDP (Y) are constant, the price level (P) will rise to maintain the balance in the equation. This is because an increase in the speed of money circulation implies that more transactions are occurring, which creates a demand-pull inflationary pressure and thus increases prices.

Effect of a Decrease in Velocity on the Price Level

If velocity (V) decreases, assuming the money supply (M) and real GDP (Y) are constant, the price level (P) should decrease to maintain the balance in the equation. This would occur because less money is circulating in the economy, which tends to decrease demand and therefore reduce prices.

Effect of an increase in the money supply on the Price Level

An increase in the money supply (M), assuming velocity (V) and real GDP (Y) are held constant, will lead to an increase in the price level (P), as the extra money will create inflationary pressure in the economy by increasing demand.

Effect of a decrease in the money supply on the Price Level

A decrease in the money supply (M), assuming velocity (V) and real GDP (Y) are held constant, will result in a decrease in the price level (P), because less money in circulation reduces demand and thereby exerts a downward pressure on prices.