Supposed there is an increase in the velocity of money caused by the increased u

Question

Supposed there is an increase in the velocity of money caused by the increased use of ATM machines. (20 points)

a. How would prices and output be affected in the short run?

b. If the Federal Reserve's objective is to keep prices stable in the short-run, how should it respond?

c. In the long run, what will happen to prices and output? If the Federal Reserve's objective is to keep prices stable in the long run, how should it respond? When should it undertake its response -- immediately or once the "long run" is reached?

d. Based upon your answer in part (c), how would you respond to those who argue that the Federal Reserve should wait until inflation appears before reacting?

Explanation / Answer

a. In the short Run Prices will remain fixed . The Output should increase to match the increase in velocity as money supply and prices are fixed.

b. As the prices will be fixed in the short run, Federal Reserve need not respond immediately.

c. In the longer runs factors of production control the output. So increase in velocity will not increase output in the long run and the increase in velocity will have to be matched by increase in price if output and money supply remains constant.

With a long term price stability goal , Federla Reserve needs to reduce the supply of money to offset the effect of higher velocity. As per quatntity theory equation MV=PY, the velocity increase is proportional to decrease in money. So Federal Reserve needs to reduce the money supply to tackle price rise issue.

d. Federal Reserve should not react before hand as reducing the money supply beforehande when prices are fixed may result in increased price level very quickly .

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