Answer to Question #95240 in Macroeconomics for komal

Question

Classical economists assumed that velocity was stable in the short run. But suppose that, because of a change in the payments mechanism—for example, greater use of credit cards— there was an exogenous rise in the velocity of money. What effect would such a change have on output, employment, and the price level within the classical model?

Answer 1

The classical theory assumes that the velocity of money and the real output are independent of the amount of money in the economy, since they tend to strive for a certain natural level, depending only on the level of technological development of production and the mechanism for making payments in society at a given time period. Only M and P become dependent variables in the equation of exchange, i.e. a change in the amount of money in the economy leads to a proportional increase in prices and, conversely, price increases require an increase in the money supply. The level of employment is also independent of velocity within the classical model.