Question

Answer each of the following questions. Answers should typically be no more than 2-3 sentences in length.

1. In the long-run model, what assumption about the demand for real money balances ensures that the velocity of money V is constant? Be sure to explain why this is the case.

2.When discussing the Quantity Theory of Money, we concluded that the nominal money supply M determined nominal GDP. Explain exactly what we meant by this.

3. In the simple formulation of the aggregate demand curve, what should the central bank do if it wants to exactly counteract a 10% rise in velocity?

Answer 1

1) In the long run changes in the money supply brings equal changes in prices so that real money supply equals real money demand and both are unchanged. WIth no change in real money demand, the velocity remains constant.

2) Quantity Theory of Money proposes that Money supply and velocity of money together determine nominal GDP. Since velocity is assumed to be constant, it is the money supply that determines nominal GDP. Precisely this implies

M x V = P x Y where P x Y is the nominal GDP. Hence nominal money supply M determins nominal GDP P x Y.

3) Total spending growth rate of aggregate demand (inflation rate + GDP growth rate) is assumed to be equal to the growth rate of money supply plus the growth rate of velocity. If the central bank wants to exactly counteract a 10% rise in velocity, it must reduce money supply by 10% so that (inflation rate + GDP growth rate) remains unchanged.