Question

Based on the equation of exchange, the money supply in the economy is calculated as a. \(M=V / P Q\) b. \(M=V(P Q)\) c. \(M V=P Q\) \(\mathrm{d} . M=P Q-V\)

Short answer

Based on the equation of exchange, the money supply in the economy is calculated as \( M V = P Q \).

Step-by-step solution

We have four variables in the equation of exchange: 1. Money supply (M): The total amount of money available in an economy. 2. Velocity of money (V): The average number of times one unit of money is used to purchase goods and services per time period. 3. Price level (P): The overall level of prices in the economy, typically measured by a consumer price index or producer price index. 4. Output (Q): The total quantity of goods and services produced in the economy. With these variables, let's analyze each of the given equations. #Step 2: Analyze Equation a#

Equation a is given by: $$ M = \frac{V}{P Q} $$ Here, M is expressed as the fraction \(\frac{V}{PQ}\). This equation suggests that the money supply equals the velocity of money divided by the product of the price level and output. This equation is not consistent with the equation of exchange, which states that the money supply multiplied by the velocity of money equals the nominal GDP, which is the product of the price level and output. #Step 3: Analyze Equation b#

Equation b is given by: $$ M = V(PQ) $$ In this equation, M is expressed as the product of V and PQ, which implies that money supply equals the velocity of money multiplied by the product of the price level and output. This equation is also inconsistent with the equation of exchange. #Step 4: Analyze Equation c#

Equation c is given by: $$ M V = P Q $$ This equation states that the money supply multiplied by the velocity of money equals the product of the price level and output, which is the nominal GDP. This equation is consistent with the equation of exchange, meaning that Equation c is the correct answer. #Step 5: Analyze Equation d#

Equation d is given by: $$ M=PQ-V $$ In this equation, M is expressed as the difference between the product of the price level and output and the velocity of money. This equation is not consistent with the equation of exchange. Therefore, it is not the correct answer. #Conclusion#

Based on our analysis, the correct equation for the equation of exchange is given by Equation c: $$ M V = P Q $$

Key concepts

Money Supply

The money supply refers to the total amount of money available in the economy at a given time. Think of it as the pool of cash and near-cash items that people have available for spending and transactions. This includes physical currency like coins and paper money, as well as balances held in demand deposits, such as checking accounts. Understanding the money supply is crucial because it influences economic conditions like inflation and interest rates. When the money supply increases, consumers typically have more money to spend, which can stimulate economic activity but might also lead to higher prices. Conversely, a decrease in money supply can suppress spending, potentially slowing down the economy.

Velocity of Money

The velocity of money measures how quickly money circulates through the economy. It is the rate at which consumers and businesses spend money, turning over from one transaction to the next. A higher velocity means money changes hands frequently, indicating a high level of economic activity. Conversely, a lower velocity implies money is sitting idle, suggesting weaker economic activity.

• If people are spending more, the velocity is higher.
• If people are saving more and not spending as much, the velocity is lower.

Economists use the velocity of money to gauge the vitality of an economy; a sudden change can signal shifts in economic confidence and consumer behavior.

Price Level

Price level refers to the average of current prices across the entire spectrum of goods and services produced in the economy. It's a snapshot of how much things cost at a particular point in time.
The price level is often measured by price indices, such as the Consumer Price Index (CPI), which tracks the average cost of a basket of goods and services over time. Changes in the price level are indicative of inflation or deflation.

• Inflation occurs when there's a persistent increase in the price level, meaning consumers need more money to buy the same amount of goods.
• Deflation is the opposite - a decrease in the price level, which can increase the purchasing power of money but might also lead to decreased spending by consumers.

Output

Output in economics refers to the total quantity of goods and services produced in an economy over a certain period. This is often measured as Gross Domestic Product (GDP). Output is a crucial indicator of economic health; it reflects the economy’s ability to meet consumer demand and grow.

• When output increases, it generally signifies economic growth, as the economy produces more goods and services.
• Conversely, a decline in output may signify economic contraction and potential issues such as high unemployment or decreased consumer spending.

Understanding output helps economists and policymakers determine the best economic strategies to promote sustained growth.