Answer to Question #308950 in Macroeconomics for Kinza Tariq

Question

8. Within the classical form of the quantity theory, the demand for money is given by

Mu = kPY

(4.7)

Suppose income (Y) is given at 400 units, and the money supply (M) is fixed at 200 units.

Suppose k drops from its initial value of 0.5 to 0.25.

What is the initial price level? What is the new price level after the change in k? Explain the

process that leads to the change in the aggregate price level.

Answer 1

The demand for money is:

Mu=kPY, therefore

p=$\frac{Mu}{kY}$

initially where M=200, k=0.5,Y=400 then,

p=$\frac{200}{0.5\times{400}}$

p=$\frac{200}{200}$

p=$1

after the change of k from 0.5 to 0.25,the new price is

p=$\frac{200}{0.25\times{400}}$

p=$\frac{200}{100}$

p=$2

In short run,since the supply of money is constant ,the inverse in change of k denotes inflation rate which leads to aggregate rise in the price.