Question

Choose the answer below that is consistent with the following data: Assume that velocity is 5, the quantity of output is 1,000 items, the price level is currently $10 and the Federal Reserve has created a total of $3,000.
(A) This economy will suffer from Deflation due to an insufficiency of money for the size of the economy.
(B) This economy will suffer from higher than normal interest rates due to an excess of money supply.
(C) This economy will suffer from an increase in the price level at some point in the future.
(D) The Fed is pursuing a contractionary monetary policy since the economy is in recession.

Answer 1

Answer:

(C) This economy will suffer from an increase in the price level at some point in the future.

Explanation:

Velocity of money is defined as the rate at which money is exchanged in an economy. It calculated the number of time money exchanges hands during transactions in the economy.

For example if two individuals have $50 each (total of $100) and they used the same money to perform total transactions of $500, the velocity of money will be 500/100= 5.

The formula for velocity of money is

Velocity of money = Gross domestic product/ Money supply

GDP (monetary value of output) = output * price

GDP= 1,000* $10= $10,000

Therefore

5 = 10,000/x

Cross-multiply

x= 10,000/5= $2,000

So money needed in the economy is $2,000. But the Federal reserve has created $3,000.

We have an excess cash of 3,000-2,000= $1,000 in the economy.

Since there is too much money in the economy people will spend more and there will be increase in demand. Supply will not be able to keep up with demand resulting in scarcity and an increase in prices. Eventually inflation will occur.