Final answer:
An increase in interest rate (R) leads to an increase in money velocity because it discourages holding cash, while an increase in real output (Y), with a money demand elasticity less than unity, results in a decrease in velocity as money circulates more slowly. This relationship is vital for central banks when targeting monetary policy, as variations in velocity can make managing inflation and unemployment challenging.
Step-by-step explanation:
The question relates to how velocity of money changes with variations in the interest rate (R) and real output (Y). The velocity of money is essentially the average frequency with which a unit of money is spent on new goods and services produced domestically in a specific period of time, often put in terms of the velocity of M1, which includes currency and checking account balances. According to economic theory, if aggregate money demand elasticity with respect to real output is less than unity, an increase in Y would mean that money changes hands less frequently, thus decreasing velocity. Conversely, an increase in R generally encourages individuals to hold less cash and do more transactions, thereby increasing velocity. However, such dynamics are not linear and may be affected by other factors such as monetary policy or shifts in money demand.
Based on the provided information, the correct answer to how velocity varies with changes in R and in Y is: An increase in R will increase velocity, while an increase in Y will decrease velocity. This is because a higher R dissuades holding cash (prompting more frequent transactions), and a higher Y with a money demand elasticity of less than unity implies money is turning over more slowly.
The variability of velocity also complicates monetary policy, as fluctuations in velocity can lead to unpredictable changes in nominal GDP, making it more challenging for central banks to target inflation and unemployment effectively. This context underscores the necessity for central banks to be adaptable and responsive to economic shifts rather than adhering to rigid monetarist principles.