Question

Assume the money supply is $500, the velocity of money is 8, and the price level is $2. Using the quantity theory of money:

a. Determine the level of real output. $ _________.
b. Determine the level of nominal output. $ ________.
c. Assuming velocity remains constant, what will happen if the money supply rises 20 percent? Nominal output would be $_______ , and real output would be $ _________ .

Answer 1

a) 2000

b) 4000

c) 2000 and 4800

Step-by-step explanation:

The quantitative theory of money shows how the monetary side of an economy behaves, that is, the effect of money supply on income. It is given by the equation MV = PY, where M = money supply, V is the currency's velocity, P is the price level and Y is the real income level.

M = 500, V = 8, P = 2

a) The real income level:

MV = PY

500 x 8 = 2 x Y

Y = 2000

b) Nominal income level (price level multiplied by real income)

PY

2 x 2000 = 4000

C) If the money supply increases by 20%, ie to 600, the real income will be:

MV = PY

600 x 8 = 2.4 x Y (Y is full employment income, so the effects of money supply will be on the price level)

Y = 2000 Real income remains the same, increase in money supply does not affect real output, only price level, which increases from 2 to 2.4.

The nominal income, in turn, will be:

PY

2.4 x 2000 = 4800

That is, an increase in the money supply only increases nominal income.