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The quantity of money theory

Dear OTA: Could you please answer these questions? I am struggling with economics and need to know what all of this means. Thank you.

**Define the Quantity of Money theory and identify whether this is a Keynesian or Classical cornerstone. Describe what happens when, according to this theory, the money supply is increased.

**Discuss whether the Federal Reserve can control both the money supply and interest rates in the United States simultaneously.

**Compare and contrast the concepts of active and passive stabilization.

**Define and distinguish debt and deficits.

**Compare and contrast the economic effects of increasing spending versus reducing taxes.

Solution Preview

Today, the quantity theory of money is espoused by monetarists, who accept the basic tenets of Keynesian theory. It is therefore Keynesian in its foundations. Because the quantity of money determines the value of money, it can be given by the equation PY = MV, where P is the price level, Y. is the real GDP, M is the money supply and V is the velocity. This equation can be represented as (percent change in the money supply) + (percent change in velocity) = (percent change in the price level) + (percent change in output). An increase in M, therefore, holding V constant (which is generally assumed) results in an increase in the price level or GDP. Monetarists argue that GDP is fixed at a long term growth rate, and the money supply must be increased only gradually in order to accommodate this growth. Attempting to increase it beyond this potential results only in inflation (an increase in P). This is therefore the reason why the Fed is so careful about its target rates. It wants to be sure that in its attempts to prevent a recession, it isn't instead causing inflation.

When the monetary authority or the legislative body of a nation want to stabilize the economy, they can choose either active or passive means. Active policy works by directly increasing consumption and government spending. Passive policies use tax rates and transfer programs instead. ...

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