Question

According to the simple quantity theory of money, what will happen to Real GDP and the price level as the money supply rises? Explain your answer.

Short answer

According to the simple quantity theory of money, an increase in the money supply might temporarily increase Real GDP as firms increase their production. However, in the long run, Real GDP would likely return to its original level if velocity and price level adjust. The price level, on the other hand, is expected to increase proportionally with an increase in the money supply, due to the excess money chasing the same amount of goods and services.

Step-by-step solution

Understand the Quantity Theory of Money

The Quantity Theory of Money says there is a direct relationship between the quantity of money in an economy and the level of prices of goods and services sold. According to this theory, when there is more money circulating in the economy, ceteris paribus, price levels will increase. The formula for the Quantity Theory of Money is \(M \times V = P \times Y\), where \(M\) stands for the money supply, \(V\) is the velocity of money or the rate at which money is exchanged, \(P\) is the price level and \(Y\) is the Real GDP. This equation implies that an increase in the money supply, holding the velocity of money and Real GDP constant, leads to an increase in the price level.

Impact on Real GDP

The impact on Real GDP from an increase in money supply can vary depending on other factors. In the short-term, an increase in the money supply might lead to an increase in Real GDP as firms use the extra capital to increase production. In the long-term, however, Real GDP might go back to its original level if the velocity of money and price level adjust accordingly. It's important to note, the quantity theory of money assumes that the economy is at full employment, implying Real GDP should not change with variations in the money supply.

Impact on Price Level

With regards to price level, the Quantity Theory of Money suggests an increase in money supply will cause a proportional increase in the price level. This is because the excess supply of money leads to more money chasing the same number of goods and services, thereby causing prices to rise.