Final answer:
The equation of exchange includes four key variables: Money Supply (M), Velocity of Money (V), Price Level (P), and Output (Q). Together, these describe the relationship between the money supply and the economy's overall level of prices and output.
Step-by-step explanation:
In the context of the equation of exchange, each variable plays a critical role in illustrating the relationship between the money supply and the economy's output:
Money Supply (M) - This variable represents the total amount of money that is circulating within an economy at any given time.
Velocity of Money (V) - This is a measure of the frequency at which one unit of currency is used to purchase domestically-produced goods and services within a certain period.
Price Level (P) - This reflects the average level of prices for all final goods and services in an economy at a particular time.
Output (Q) - Also known as real Gross Domestic Product (GDP), this variable measures the total dollar or market value of all final goods and services produced within the borders of a country in a given year.
Understanding these variables is essential for analyzing how changes in the money supply can affect aspects like inflation, GDP, and purchasing power within an economy.