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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).
