Question

On my professors review sheet he ask,

Does money supply affect real variables like real GDP or the real interest rate?

I thought a change in money supply (M) does not change any 'real' variables according to the Quantity Theory of Money. Is this a trick question?

Answer 1

According to classical dichotomy theory money is neutral, it means any change in money supply would not affect real variable it will affect only nominal variable.

Real variable measured is physical unit like quantity of output produced.

nominal variable measured in money units like nominal wage.

So, in quantity theory of money.

M * V = P * Y.

Where, M is money supply.

V is velocity of money.

P is price level.

And Y is real GDP.

Since velocity remains constant and Y is real variable.

Then an increase in money supply would lead to an increase in the price level (P) by same proportion in order to hold the quantity theory of money true.