Question

Mainstream economists contend that the equation of exchange breaks down because:

A) there is a tight relationship between the money supply and nominal GDP
B) velocity is more variable and unpredictable than expected
C) the money supply increases at a constant, not a variable rate
D) nominal GDP is directly related to changed in the price level

Answer 1

The equation of exchange breaks down mainly due to the unpredictable variability of velocity, which makes the relationship between changes in the money supply and nominal GDP less reliable. The correct option is B) velocity is more variable and unpredictable than expected

Step-by-step explanation:

Mainstream economists argue that the equation of exchange breaks down primarily because velocity is more variable and unpredictable than expected.

The equation of exchange is represented as Money Supply X Velocity = Nominal GDP = Price Level x Real GDP. This relationship highlights that if velocity is constant, changes in the money supply should have a direct and predictable effect on nominal GDP.

However, changes in velocity can disrupt this predictability. If velocity is not constant and fluctuates unpredictably, the relationship between money supply changes and nominal GDP becomes less reliable, undermining the practical utility of the equation of exchange. The correct option is B) velocity is more variable and unpredictable than expected