Question

Suppose that the quantity of money in circulation is fixed but the income velocity of money doubles. If real GDP remains at its long-run potential level, what happens to the equilibrium price level?

Answer 1

The equilibrium price level will double.

Step-by-step explanation:

Suppose that the economy has a money supply of $4 billion and the income velocity of money is 8, the price level will be 4 and the real GDP is $8 billion. The formula we are using is:

• Money supply x velocity = price level x real GDP

If the money supply remains the same ($4 billion), the income velocity of money is 16 (it doubles), and the real GDP is $8 billion, then the price level will be:

$4 x 16 = price level x $8

$64 = price level x $8

price level = $64 / $8 = 8

So the price level has doubled to 8.