Q6. Use the equation of exchange to ... [FREE SOLUTION]

Chapter 19: Q6. (page 404)

Use the equation of exchange to explain the rationale for a monetary rule. Why will such a rule run into trouble if V unexpectedly falls because of, say, a drop in investment spending by businesses?

Short Answer

Expert verified

The equation of exchange complies with the monetary rule as V is assumed stable.

If V unexpectedly falls, the monetary rule will run into trouble because the nominal GDP will change by a larger number.

Step by step solution

Monetary rule

The monetary rule suggests that the Fed expand the money supply each year at the same annual rate as the typical growth of the economy鈥檚 production capacity. Such a rule will avoid the instability generated by the monetary policy by avoiding inflation or recession.

Equation of exchange and monetary rule

The equation of exchange is MV = PQ.

When V is constant, the money supply M, a constant increase in the variable as per monetary rule in the LHS will determine constant proportionate changes in the RHS when multiplied by the velocity V. A steady rise in M as suggested by the monetary rule makes the change in the productive capacity (PQ) in a systematic way that avoids instability.

If V falls

If the investment spending reduces, the value of V falls, the monetary rule of the steady increase in the money supply will not work. When V falls, the steady change in money supply will change the nominal output by a lesser proportion. In the above equation, falling V will reduce the value in LHS. So, to maintain equality, the value of RHS should also fall.