Assume that wages and prices are fully flexible and all inflation is correctly anticipated.

According to the quantity theory of money, what would be the impact of expansionary monetary policy on real output and the price level?

Choose 1 answer:
Real output increases, no impact on price level
(B) Real output increases, price level increases
(C) Real output decreases, price level decreases
(D) No impact on real output, no impact on the price level
(E) No impact on real output, price level increases

Question

Assume that wages and prices are fully flexible and all inflation is correctly anticipated.

According to the quantity theory of money, what would be the impact of expansionary monetary policy on real output and the price level?

Choose 1 answer:
Real output increases, no impact on price level
(B) Real output increases, price level increases
(C) Real output decreases, price level decreases
(D) No impact on real output, no impact on the price level
(E) No impact on real output, price level increases

Accepted Answer

∻Solution by Steps∻ ‖ step 1 ⋮ Apply the Quantity Theory of Money, which is expressed by the equation $ MV = PY $, where $ M $ is the money supply, $ V $ is the velocity of money, $ P $ is the price level, and $ Y $ is the real output. ‖ ‖ step 2 ⋮ Recognize that an expansionary monetary policy increases the money supply ($ M $), and if the velocity of money ($ V $) is unchanged, the product of the price level ($ P $) and real output ($ Y $) must increase. ‖ ‖ step 3 ⋮ Since wages and prices are fully flexible and inflation is correctly anticipated, the increase in the money supply will lead to an increase in the price level ($ P $), but it will not affect the real output ($ Y $) in the long run, according to the classical dichotomy. ‖ ‖ step 4 ⋮ Therefore, the correct answer must reflect an increase in the price level without a change in real output in the long run. ‖ ∻Answer∻ ***E*** ∻Key Concept∻ ⚹Classical Dichotomy and Quantity Theory of Money⚹ ∻Explanation∻ ⚹In the long run, with fully flexible wages and prices, and correctly anticipated inflation, changes in the money supply only affect nominal variables (like the price level) and not real variables (like real output), according to the classical dichotomy and the Quantity Theory of Money.⚹◊What is the formula for calculating the impact of expansionary monetary policy on real output and the price level according to the quantity theory of money?⍭ Generate me a similar question◊

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