Problem:

Suppose an economy's nominal GDP is $5000 billion and the money supply is $1000 billion.

1. What is velocity of money in the economy?
2. Suppose the velocity is constant and equal to the value just computed. If the money supply increases by 2%, what do you predict will happen to nominal GDP?

Answer:

1. The equation of exchange states that MV = PQ where M is the money supply, V is velocity, and PQ is price times output, or nominal GDP. Rearrange this equation to find that V = PQ/M. In this economy, V = $5000/$1000 = 5.
2. A 2% increase implies a new money supply of 1.02 x $1000 = $1020 billion. This value multiplied by the velocity, 5, gives the new level of nominal GDP. Nominal GDP will rise to $1020 x 5 = $5100 billion.