Recall the quantity equation, MV = PY. In the Classical framework using the quan

Question

Recall the quantity equation, MV = PY. In the Classical framework using the quantity equation, a 5% increase in M causes a 5% increase in P without affecting Y. Bearing in mind the effect of a decrease in interest rates on investment spending and real GDP (Y), use Liquidity Preference and AS/AD, explain why a 5% increase in M will cause less than a 5% increase in P in the short run. Assuming the economy was at full employment before the money supply increase, use AS/AD analysis to explain why the full 5% increase in P will occur in the long run.

Explanation / Answer

Ans: Rise in M will increase output as well as price but what would increase more, depends on short/long run. In the short run, prices are sticky thats why direct relationship between M and price does not hold. Velocity of money doesn't remain constant over the time. In short run, P doesn't get full effect of rise in M. Whereas in long run , market system gets full time to adjust . At full employment level only one thing can rise i.e Price because there is no space to rise output.

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