Answer to Question #221045 in Marketing for saleemaslam

Question

1.     Give the equation of exchange and explain the variables used in it. Why we call it an identity?

2.     Describe the factors that affect the demand for money.

3.     Why is the aggregate demand curve downward sloping?

Answer 1

1)     The equation of exchange is given by M × V = P × Y, where M is the money supply, V is the velocity of money, P is the price level and Y is aggregate output or income. It is an identity because it is a relationship that is true by definition. It does not tell us, for example, that when the money supply M changes, nominal income (P × Y) changes in the same direction: a rise in M for example could be offset by a fall in V that leaves M × V unchanged and therefore P × Y unchanged.

2)     Money demand is influenced by three key factors: national income, price level, and interest rate. The first two factors have a direct relationship with transaction and precautionary demand, whereas speculative demand for money has an inverse relationship with the market rate of interest.

3)     Aggregate demand is skewed downward because of the wealth impact. The aggregate demand curve is drawn assuming that the government maintains a constant money supply. Money supply can be seen of as a representation of the economy's wealth at any one time.