Question

Suppose that the money supply is \(\$ 1\) trillion and money velocity is \(4 .\) Then the equation of exchange would predict nominal GDP to be: b. \$4 trillion. c. \(\$ 5\) trillion. d. \(\$ 8\) trillion.

Short answer

The nominal GDP is predicted to be \$4 trillion.

Step-by-step solution

Understanding the Equation of Exchange

The equation of exchange is given by the formula \( MV = PQ \), where \( M \) represents the money supply, \( V \) represents the velocity of money, \( P \) is the price level, and \( Q \) is the real output or quantity of goods and services sold. The term \( PQ \) represents the nominal GDP.

Substituting Known Values

We are given that the money supply \( M = \$1 \) trillion and the velocity of money \( V = 4 \). We substitute these values into the equation \( MV = PQ \) to find the nominal GDP.

Calculating Nominal GDP

Substituting the known values, we have \( 1 \times 4 = PQ \). Thus, \( PQ = \$4 \) trillion.

Key concepts

Money Supply

Money supply refers to the total amount of money available in an economy at a particular time. It is a crucial instrument used by a country's central bank or treasury to regulate economic activity. Various categories define the money supply, including cash, coins, and balances held in checking and savings accounts.

The control of the money supply directly impacts interest rates and inflation within an economy. When the money supply increases, it usually lowers interest rates, making borrowing cheaper for businesses and individuals. This, in turn, can stimulate economic growth by increasing consumption and investment. Conversely, a decrease in the money supply can raise interest rates, which tends to cool inflation and slow down economic expansion.

Understanding money supply is vital for determining economic policy and predicting economic conditions. It is often the starting point in the equation of exchange, symbolized by the letter \( M \) in the formula \( MV = PQ \). In this equation, the money supply combines with the velocity of money to determine nominal GDP.

Velocity of Money

The velocity of money (\( V \)) is an indicator of how frequently a unit of currency is used to purchase goods and services within a given time period. It is an essential aspect of economic analysis because it provides insight into the speed at which money circulates throughout an economy.

Higher velocity implies a more active economy, as money changes hands quickly. This scenario means people are spending more rapidly, potentially boosting economic output. On the other hand, a lower velocity may indicate a slow-moving economy, where money is changing hands less frequently.

Several factors can affect the velocity of money, such as economic confidence, interest rates, and credit availability. During times of economic uncertainty, the velocity of money can decrease as individuals and businesses hold onto their money rather than spending or investing it.

In the equation of exchange:

• \( \text{MV} = \text{PQ} \)
• \( V \) represents the velocity of money.

A change in the velocity of money impacts the nominal GDP (\( PQ \)), making it a crucial element in economic forecasting and policy-making.

Nominal GDP

Nominal GDP represents the market value of all finished goods and services produced within a country's borders in a specific time period, without taking inflation into account. It's an important economic metric as it reflects the overall economic output and provides a snapshot of a nation's economic health.

Unlike Real GDP, which is adjusted for inflation, Nominal GDP can be influenced by changes in price level, currency strength, and production volume. In periods of high inflation, Nominal GDP may appear larger than Real GDP because it does not adjust for price changes.

In the equation of exchange, Nominal GDP is expressed as the product of the price level (\( P \)) and the quantity of goods and services (\( Q \)), captured in \( PQ \). This relationship highlights how changes in the money supply and velocity can affect a country's economic productivity.

From a policy-maker's perspective, monitoring Nominal GDP is key, as it helps to make informed decisions regarding fiscal and monetary policy, to strive for economic stability and growth.