The equation of exchange becomes a theory in which the quantity of money explains prices based on the assumption of classical economists that:
a. both the velocity of money and real output are constant for an economy in the short run equilibrium.
b. both the velocity of money and real output are constant for an economy in the long run equilibrium.
c. the velocity of money is constant, whereas the quantity of output changes rapidly in an economy.
d. the real output is constant whereas the velocity of money changes constantly in an economy.
The correct answer and explanation is:
The correct answer is b. both the velocity of money and real output are constant for an economy in the long-run equilibrium.
Explanation:
The equation of exchange is a fundamental concept in economics, expressed as:
MV = PQ
Where:
- M is the money supply,
- V is the velocity of money,
- P is the price level,
- Q is the real output (real GDP).
This equation represents the relationship between the total money supply in the economy, the velocity of money, and the overall price level and output. When classical economists apply this equation as a theory to explain prices, they make certain assumptions.
The classical assumption is that in the long run, the economy tends toward equilibrium. This means that both the velocity of money (V) and real output (Q) are constant. The velocity of money, in this case, is assumed to be stable because the amount of money circulating in the economy is relatively predictable, and real output is determined by factors like technology, labor, and capital, which do not fluctuate in the short run.
In the long-run equilibrium, output is typically seen as being fixed at its natural level, determined by factors such as labor, capital, and technology. The money supply (M) influences the price level (P), but since output (Q) is constant in the classical model, any increase in the money supply leads to a proportional increase in prices.
The classical theory of the quantity theory of money assumes that changes in the money supply directly affect the price level, as long as output and velocity are assumed to be stable. This is why changes in the money supply in the long run primarily impact inflation (price levels), rather than affecting real output or employment.