Due to a change in monetary policy, the money supply in a certain country is reduced. Bob says that this will likely lead to a decrease in the velocity of money and an increase in the average price level of goods. Is Bob correct? Explain your answer using the equation of exchange.(1 point)

Question

Responses

Bob is not correct. The money supply, the velocity of money, and the average price level of goods always change in the same way as each other.
Bob is not correct. The money supply, the velocity of money, and the average price level of goods always change in the same way as each other.

Bob is not correct. If both the money supply and the velocity of money decreased, the average price level of goods would likely decrease as well.
Bob is not correct. If both the money supply and the velocity of money decreased, the average price level of goods would likely decrease as well.

Bob is not correct. The money supply and the velocity of money always change in opposite ways.
Bob is not correct. The money supply and the velocity of money always change in opposite ways.

Bob is correct. The money supply and the velocity of money always change in the same way as each other, which will be the opposite of the change to the average price of goods.

Answer 1

Bob is not correct. If both the money supply and the velocity of money decreased, the average price level of goods would likely decrease as well.

To explain this using the equation of exchange, which is:

\[ MV = PY \]

where:

• \( M \) is the money supply,
• \( V \) is the velocity of money,
• \( P \) is the average price level, and
• \( Y \) is the real output or real GDP.

If there is a reduction in the money supply (\( M \)), and if the velocity of money (\( V \)) also decreases (which is possible in a contractionary economic environment), then for the equation to hold and given that \( Y \) (the real output) is typically assumed to remain constant in the short run (or may not decrease significantly), the average price level (\( P \)) must also decrease or remain stable.

Thus, if both \( M \) and \( V \) decrease, it is likely to lead to a reduction in \( P \), not an increase. Therefore, Bob's assertion that a reduction in money supply would lead to an increase in the average price level is incorrect.