Question

1. In the simple quantity theory of money, changes in the money supply affect the price level, but not real GDP. Do you agree or disagree with this statement. Explain your answer.

2. What are the assumptions and predictions of the simple quantity theory of money? Does the simple quantity theory of money predict well?

Answer 1

1. Since the SRAS curve is vertical in the simple quantity theory, an increase in the money supply (which shifts the AD curve rightward) will increase the price level but have no change on Real GDP.

2. The assumptions of the simple quantity theory of money are that velocity and output are constant. If these two assumptions hold true, then there is a strictly proportional link between changes in the money supply and changes in prices. In the real world we do not always observe this strict proportionality but we do observe a strong direct relationship between money supply growth rates and price level growth rates.