Answer to Question #194072 in Macroeconomics for Larna M

Question

Explain the classical quality theory of money.

Answer 1

Solution:

The classical quantity theory of money states that when the money supply increases the overall price level rises and conversely falls when the money supply declines. That is, the money supply and price level in an economy are in direct proportion to one another, such that when there is a change in the supply of money, there is a proportional change in the price level and vice-versa.

It is associated with the classical price adjustment since the decrease in demand would result in a reduction of the price level until the initial equilibrium is attained.  

It also states that the supply of money times the velocity of money equals to nominal GDP.

It is supported and calculated by utilizing the Fisher Equation on the quantity theory of money:

Money supply $\times$ velocity of money = price level $\times$ real GDP