Question

In an equation-of-exchange framework, the price level is dependent upon the money supply, velocity, and Real GDP. Do you agree or disagree? Explain your answer.

Short answer

Yes, the price level is dependent upon the money supply, velocity, and Real GDP according to the equation of exchange. If any of these variables change, and the others remain constant, the price level will have to adjust to keep the equation in balance.

Step-by-step solution

Understand the Equation of Exchange

The equation of exchange, derived from the quantity theory of money, is given by MV = PQ. It states that the money supply times the velocity of money equals the price level times the Real GDP. The price level (P) is thus assumed to be directly influenced by the money supply (M), the velocity of money (V), and the Real GDP (Q).

Analyze the Dependency of Price Level

The price level in an economy is dependent on the velocity of money and the level of real output. However, the central concept is that the total spending (MV) should equal the total amount received for output (PQ). If the velocity of money or the real GDP change, and money supply stays the same, the price level will adjust accordingly. Similarly, if the money supply changes and velocity and real GDP stay the same, the price level will adjust.

Form Your Conclusion

Due to the relation given in the equation of exchange, it can be stated that the price level is dependent on the money supply, velocity, and Real GDP. If either the money supply, velocity, or Real GDP changes, without a counteracting change in one of the others, the price level will have to adjust to maintain the equality MV = PQ. There may be other influences on the actual price level in real-world economies, but in the context of the equation of exchange, this conclusion holds.