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

a. 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.

b. 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.

c. 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.

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

Answer 1

To analyze Bob's statement, we can use the equation of exchange, which is represented as:

\[ MV = PY \]

Where:

• \( M \) = money supply
• \( V \) = velocity of money
• \( P \) = average price level of goods
• \( Y \) = real output (or real GDP)

If the money supply (\( M \)) is reduced, it can have several implications. According to the equation:

1. If \( M \) decreases and \( Y \) (real output) remains constant in the short term, to maintain the equation, either \( V \) or \( P \) must also change.
2. If Bob believes that there will be a decrease in the velocity of money (\( V \)) and an increase in the average price level (\( P \)), then it does not logically follow because a decrease in \( M \) paired with a decrease in \( V \) would lead to a decrease in \( P \), assuming \( Y \) is constant.

Considering these implications, the correct response would be:

c. 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.