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Problem : Describe the money market.

The supply of money in the money market comes from the Fed. The Fed has the power to adjust the money supply by increasing or decreasing the number of bills in circulation. Nobody else can make this policy decision. The demand for money in the money market comes from consumers. In general, consumers need money to purchase goods and services. The value of money and the price level are ultimately determined by the intersection of the money supply, as controlled by the Fed, and money demand, as created by consumers.

Problem : Draw a diagram depicting the money market.

The money market

Problem : Describe what happens to the value of money and the money market when the Fed increases the money supply. Diagram the change.

Shift in the money market
The money supply curve shifts out with an increase in the money supply. The new intersection of the money supply curve and the money demand curve is at a lower value of money but a higher price level. With more money in circulation, each bill is worth less. Therefore, the value of money decreases, it takes more bills to purchase goods and services, and the price level increases accordingly.

Problem : Describe the quantity theory of money.

The quantity theory of money states that the value of money is based on the quantity of money in the economy. Thus, according to the quantity theory of money, when the Fed increases the money supply, the value of money falls and the price level increases.

Problem : How are the velocity of money, the money supply, and the nominal GDP related?

The relationship between velocity, money supply, price level, and nominal GDP is represented by the equation M * V = P * Y where M is the money supply, V is the velocity, P is the price level, and Y is the quantity of output. P * Y, the price level multiplied by the quantity of output, gives the nominal GDP. The equation for the velocity of money can be converted to a percentage change formula for easier calculations. In this case, the equation becomes (percent change in the money supply) + (percent change in velocity) = (percent change in the price level) + (percent change in output).