Question

In the long run, an increase in the money supply will lead to

A a decrease in velocity.

B a decrease in nominal GDP.

C an increase in nominal GDP.

Answer 1

Answer

The correct answer is (c) an increase in nominal GDP

According to quantity theory of money MV = PY

where M = Money supply, V = Velocity of money and is assumed to be constant, P = Price level , Y = Real GDP and in the long run Real GDP depends on Factors of production where in the long run Factors of production are fully employed and hence Real GDP(Y) is constant.

So MV = PY and V and P are constant.

If M increases then P will also increase. Nominal GDP = P*Y and thus if P increases PY will also increase and hence Nominal GDP = PY will increase.

ALTERNATIVE WAY :

If Money supply increases then LM curve will shift to the right which results in rightward shift of Aggregate demand(AD) curve.

In the Long Aggregate Supply(AS) curve is Vertical where Aggregate real output = Full employment level of output. Thus this rightward shift in AD will result in increase in price level and Real Output(Y) will remain same. Hence Nominal GDP = P*Y will increase. Thus option (c) is the correct answer.

Hence, the correct answer is (c) an increase in nominal GDP