Question

(a) Derive the equation for velocity from the Liquidity Preference Equation.

(b) Explain how a change in the real GDP (Y) and the interest rate (i) affects the velocity of money.

Answer 1

Quantity theory of money; MV=PY
Where,
M= money supply
V= velocity of circulation of money
P= price level
Y = level of output
Velocity of money is the average number of times a dollar spent per year. So deriving the equation for velocity of money from the about money demand equation is;
V = PY/M. From here, the interest rate increases the velocity of money reduced.
When the real GDP changes, the velocity will be fluctuated. If there is an increase in real GDP, there is high level of transaction. People wish to consume more. Thus the transaction motive rises. There is a positive relation between real GDP and velocity of money. Velocity of money is the measure of GDP.
If there is high rate of interest people will not want to hold money in hand. They wish to exchange it faster. Thus the velocity is very high. So when interest rate increases the velocity of money also increased.