Question

If \(\mathrm{MV}\) rises, \(\mathrm{PQ}\) (LO1) a) must rise c) must stay the same b) may rise d) must fall

Short answer

Based on the analysis of the Quantity Theory of Money, the correct answer is (b) PQ may rise, as it accounts for the possibility of other factors influencing the Price Level and Real Output in response to an increase in the Money Supply (MV).

Step-by-step solution

Understand the Quantity Theory of Money

The Quantity Theory of Money states that the money supply (M) times the velocity of money (V) is equal to the nominal value of all goods and services in the economy: MV = PQ, where P is the price level and Q is the real output. This equation forms the basis of our analysis.

Option a: PQ must rise

If MV rises and the relationship MV = PQ holds, then an increase in MV must also result in an increase in PQ. In this case, the price level (P), the real output (Q), or both may increase, depending on the economic conditions.

Option b: PQ may rise

In this option, the statement considers that an increase in MV may cause an increase in PQ. This implies that there might be other factors, such as economic conditions or government policies, influencing the Price Level and Real Output, and they might mitigate or even nullify the impact of a rise in MV.

Option c: PQ must stay the same

According to this option, an increase in MV would have no effect on PQ. This would imply that the relationship MV = PQ does not hold true, which contradicts the Quantity Theory of Money.

Option d: PQ must fall

This option suggests a negative relationship between MV and PQ, meaning that an increase in MV causes a decrease in PQ. However, this contradicts the Quantity Theory of Money, which indicates a positive relationship between MV and PQ.

Select the correct option

Based on the analysis of all four options, we can conclude that the correct option is (b) PQ may rise, as it accounts for the possibility of other factors influencing the Price Level and Real Output in response to an increase in the Money Supply (MV).

Key concepts

Money Supply

The concept of money supply refers to the total amount of money available in an economy at a specific time. It includes all physical currency and various types of deposits and assets that can easily be converted into cash.
The money supply is essential because it influences a range of economic variables such as inflation, interest rates, and ultimately, economic growth.

• Higher money supply generally means more money in circulation which can spur economic activity but might also cause inflation if it grows too quickly.
• A lower money supply can lead to slower economic activity but may help control inflation.

Understanding how money supply changes affect the economy helps predict trends in spending, saving, and investing.

Velocity of Money

Velocity of money measures how quickly money moves through the economy. It tells us how often each unit of currency is used to purchase goods and services within a time period.
This is crucial as it indicates the economy's activity level.

• A high velocity means that money is exchanging hands swiftly and could signal a robust economy with high levels of transaction and economic dynamism.
• A low velocity could point to economic sluggishness, where money changes hands less frequently, suggesting slower transaction rates and possibly an increase in savings.

The velocity of money, coupled with the money supply, plays a vital role in determining the nominal value of economic transactions.

Price Level

The price level is the average of current prices across the entire spectrum of goods and services produced in the economy. It is often represented by price indices such as the Consumer Price Index (CPI) or the Gross Domestic Product (GDP) deflator.
Changes in the price level are indicative of inflation (a rise in the price level) or deflation (a decrease in the price level).

• When the money supply increases rapidly without a corresponding increase in real output, it is likely to cause higher inflation, raising the price level.
• Conversely, if the money supply stays constant but real output increases, the price level could decrease, leading to deflationary tendencies.

Stabilizing the price level is crucial to maintain purchasing power and economic stability.

Real Output

Real output refers to the total value of all goods and services produced in an economy, adjusted for inflation. It is closely tied to the concept of GDP, providing insight into the economy's true performance level.
By focusing on real output, we look at the actual economic productivity and gains in living standards without the inflation-related distortions.

• Increased real output signifies a growing economy and often correlates with improvements in employment and income levels.
• However, if an increase in money supply raises prices without a rise in real output, it could lead to inflation without real economic growth.

Understanding real output helps policymakers craft better economic policies aimed at sustainable growth.