Money
Velocity
Let's try an example. What is the effect of a 3% increase in the money supply on the price level,
given that output and velocity remain relatively constant? The equation used to solve this
problem is (percent change in the money supply) + (percent change in velocity) = (percent
change in the price level) + (percent change in output). Substituting in the values from the
problem we get 3% + 0% = x% + 0%. In this case, a 3% increase in the money supple results in a
3% increase in the price level. Remember that a 3% increase in the price level means that
inflation was 3%.
In the long run, the equation for velocity becomes even more useful. In fact, the equation shows
that increases in the money supply by the Fed tend to cause increases in the price level and
therefore inflation, even though the effects of the Fed's policy is slightly dampened by changes in
velocity. This results a number of factors. First, in the long run, velocity, V, is relatively constant
because people's spending habits are not quick to change. Similarly, the quantity of output, Y, is
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 Fall '08
 JOMINY
 Microeconomics, Inflation, Quantity Theory of Money, 5%, 0%, 3%, Fed

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