The equation of exchange is MV = PQ, where M is the money supply, V is the veloc
ID: 1242766 • Letter: T
Question
The equation of exchange is MV = PQ, where M is the money supply, V is the velocity of money, P is the price level, and Q is real GDP. The island economy of Monet is rather simple. The only good produced in Monet is "Things," and the island is able to produce 1,000 Things each year. Each Thing sells for a price of $40. The money supply consists of 800 one-dollar bills. 6.2. A fire on the island of Monet destroys half of its one-dollar bills. According to classical economists, what will happen on the island of Monet in the short run? A. The value of the velocity will double. B. The real GDP of Monet will rise to 2,000 Things. C. The real GDP of Monet will fall to 500 Things. D. The price of Things will fall to $20.Explanation / Answer
According to the classical theory real factors in an economy remain unchanged while wage rates and prices are perfectly flexible such that output remains constant at its full employment level.Thus classical theory predicts a one to one relationship between money supply and price level.
In the above scenario when fire destroys half of the 800 one dollar bills, money supply falls to 400 dollars.Thus according to the classical theory with one to one and proportional relation between price and money supply this would lead to a one to one adjustment in price of 'things'. Hence the end result is that price of things will fall to $20.
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