Question

If velocity and aggregate output remain constant at $5$and $\backslash (1,000$billion, respectively, what happens to the price level if the money supply declines from $\backslash )400$ billion to$\$300$ billion?

Short answer

Price level falls from$\$2$to$\$1.63$.

Step-by-step solution

Step 1. Define velocity.

A velocity of an item is a function of frequency and is defined as the rate of growth of its location with respect to the criteria of reference.

Step 2. What happens to the price level?

$M\times V=P\times Y$

At the initial stage:

$\begin{array}{rcl}V& =& 5\\ Y& =& 1,000\\ M& =& 400\end{array}$

So,

$\begin{array}{rcl}400\times 5& =& P\times 1000\\ P& =& \frac{2000}{1000}\\ & =& 2\end{array}$

$\begin{array}{rcl}V& =& 5\\ Y& =& 1,000\\ M& =& 325\end{array}$

$\begin{array}{rcl}325\times 5& =& P\times 1000\\ P& =& \frac{1625}{1000}\\ & =& 1.625\end{array}$

So, price level falls from $2$to$1.63$.