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IAI Actuarial Core Principles · Business Economics · Role of money and interest rates in the economy

In the Fisher equation of exchange, MV = PT, which of the following statements best describes the classical quantity theory conclusion when V and T are assumed constant?

When velocity and transactions are constant, the price level changes in proportion to the money supply. Money growth is therefore the cause of inflation, while real output is determined by real factors such as resources and technology rather than by money.

  1. AChanges in the money supply lead to proportional changes in the price levelCorrect
  2. BChanges in the money supply lead to proportional changes in real output
  3. CChanges in the money supply lead to inverse changes in velocity
  4. DChanges in the price level cause the money supply to fall
  5. Changes in the money supply have no effect on nominal variables

Explanation

With V and T fixed, P = MV/T, so P moves in proportion to M. Real output is assumed determined by real factors, so option 1 is wrong. The theory says money is not neutral for nominal variables, as it drives the price level.

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