Problem 3 In the simple quantity theory of... [FREE SOLUTION]

Chapter 14: Problem 3

In the simple quantity theory of money, the \(A S\) curve is vertical. Explain why.

Short Answer

Expert verified

The Aggregate Supply (AS) curve is vertical in the simple quantity theory of money because the theory postulates that in the long run, an increase in the money supply will only lead to an increase in the average price level, while the quantity of goods and services that firms are willing and able to produce remains constant. This is graphically represented by a vertical AS curve, signifying no change in output regardless of price levels.

Step by step solution

Understand the Simple Quantity Theory of Money

The simple quantity theory of money states that the overall amount of spending in the economy, or money supply (M), multiplied by the velocity of money (V), equals the average price of goods (P) times the total amount of goods produced (Y). This is represented as \(MV = PY\). According to this theory, the velocity of money (V) and the total amount of goods produced (Y) are held constant in the short term, meaning that a change in money supply (M) will exactly equal a change in the price level (P).

Understand the Aggregate Supply Curve

The Aggregate Supply (AS) curve represents the total quantity of goods and services that firms are willing and able to produce at different levels of prices. In the short run, this curve is typically upward sloping showing a direct positive relationship between the level of prices and the quantity of output produced. However, in the context of the quantity theory of money, we consider the long-run scenario.

Align the Theory with AS Curve

In the long run, according to the simple quantity theory of money, the aggregate supply curve is vertical. This is because an increase in the price level resulting from an increase in the money supply doesn't change the quantity of goods and services that firms produce. Instead, it merely increases the price level. This means that no matter the average level of prices (P), the amount of goods and services that is produced (Y) remains constant.