Question

Suppose velocity rises and the money supply falls.

How will things change in the AD–AS framework if a change in the money supply is completely offset by a change in velocity? Check all that apply.

The increase in velocity could shift the AD curve to the left by the same amount as the fall in the money supply shifts the AD curve to the right.

Changes in the money supply would have no effect on Real GDP, the short-run price level, nor the long-run price level.

A change in the money supply would decrease Real GDP, the short-run price level, and the long-run price level.

The increase in velocity could shift the AD curve to the right by the same amount as the fall in the money supply shifts the AD curve to the left.

Answer 1

The correct answers are -

* Changes in the money supply would have no effect on Real GDP, the short-run price level, nor the long-run price level

* The increase in velocity could shift the AD curve to the right by the same amount as the fall in the money supply shifts the AD curve to the left

Explanation

Money velocity is the rate at which money changes hands in the economy. When money velocity is robust, it implies strong economic activity. Therefore, any shift in aggregate demand curve to the left will be offset by an increase in money velocity and the aggregate demand curve will shift to the right by the same amount.

A good example is strong economic activity and credit growth in the economy even as central banks pursue contractionary monetary policy. Just as an example, interest rates in the United States increased between 2004 and 2007 (reduction in money supply). During the same period credit growth in banks increased and economic activity was robust with higher money velocity.