Question

Consider the equation of exchange (Quantity Theory of Money). Imagine that it is true that velocity is fixed. Show that money demand does not depend on interest rates. If this is true, draw a graph of Money Demand.

Answer 1

Velocity refers to measure of how often money “turns over” in a period; and is computed as nominal GDP divided by the nominal money supply. When quantity theory of money assumes that velocity is fixed, which indicates that real money demand is proportional to real income and is unaffected by the real interest rate, thus quantity equation turns to theory of the effects of money, called the quantity theory of money. Since velocity is constant, a change in the quantity of money (M) must cause a same change in nominal GDP (PY). Thus quantity of money determines the money value of the economy’s output.

Since demand for money does not depend on the interest rate, thus the LM curve is vertical (because the demand now will equal to money supply only at the specific level of income, Y for which that is true for all r).