Assuming full employment in the classical model, if velocity increases and the government wants stable prices, the government should
A) increase the money supply.
B) decrease the money supply.
C) do nothing.
D) increase government spending.

Question

Quizplus · Accepted Answer

In the classical model, assuming full employment, an increase in velocity will lead to an increase in nominal GDP. To keep prices stable, the government should decrease the money supply to offset the increase in velocity and maintain a stable price level. This is based on the quantity theory of money, which states that MV=PY, where M is the money supply, V is the velocity of money, P is the price level, and Y is real GDP. Therefore, a decrease in M is necessary to maintain a stable P when V increases. Doing nothing or increasing government spending would not directly address the increase in velocity and would not ensure stable prices.

Assuming Full Employment in the Classical Model, If Velocity Increases