Answer to Question #66821 in Macroeconomics for Andre

Question

Consider the following statement in the short-run and the long-run: “The quantity theory of money (quantity equation) states than an increase in the money supply will lead to an equiproportionate increase in the price level”. Is this true or false? Explain.

Answer 1

The statement is TRUE. Why is it so? According to the Quantity Theory of Money the demand of money is created depending on one of the functions of money called Medium of Exchange. It can be expressed by the following equation:
MV=PY
where
M –is supply of money or the quantity of the money in circulation,
V – is the speed of circulation,
P – is prices level,
Y –is the real output
The level of V is very stable and can be changed very difficult. For example it can be changed by the new technologies which can cause fastening of the money circulation. It means that if money supply changes, proportionally the nominal level of output (PY) will change. However, according to classical theory, real output changes take place very slowly and even in the short periods the output level can be fixed, that is why the nominal output change will be caused mainly by the proportional change in the prices level.