Question

Suppose that the money supply and the nominal GDP for a hypothetical economy are \(96 billion and \)336 billion, respectively. What is the velocity of money? How will households and businesses react if the central bank reduces the money supply by $20 billion? By how much will nominal GDP have to fall to restore equilibrium, according to the monetarist perspective?

Short answer

The velocity of money is 3.5.

The households will reduce the purchase, and the businesses will reduce the sales when the central bank reduces the money supply.

The nominal GDP will have to fall by $70 billion to restore equilibrium.

Step-by-step solution

Explanation for part (a)

The monetarists have given the following equation of exchange:

$$\begin{gathered} \mathrm{Money}\mathrm{Supply}\times \mathrm{Velocity}=\mathrm{Nominal}\mathrm{GDP} \\ 96\times \mathrm{Velocity}=336 \\ \mathrm{Velocity}=\frac{336}{96}=3.5 \end{gathered}$$

So, the velocity of the money is 3.5.

Explanation for part (b)

When the central bank reduces the money supply, the equilibrium output in the economy shrinks. The interest rate will increase due to the money supply so that the investment will become costlier, and businesses will produce less. The higher interest rate incentivizes the households to invest rather than spend. Hence, the purchase by the households reduces.

Explanation for part (c)

A reduction in money supply by $76 billion will reduce the GDP by $70 billion.

Inserting this new value into the earlier exchange equation:

$$\begin{gathered} 76\times 3.5=NominalGDP \\ NominalGDP=266 \end{gathered}$$

The decrease in the nominal GDP is 336 – 266 = $70 billion.