Difficulty: Easy

Average Score: 76%

Which of the following defines the equation of exchange?

Rationale

The equation of exchange states that the money supply multiplied by the velocity of money equals nominal income.

The equation of exchange is a fundamental concept in monetary economics and is expressed as:

MV=PQ

In this equation:

M = quantity of money (money supply)
V = velocity of money, or the number of times money is spent during a given period
P = price level
Q = quantity of goods and services produced

The product of P × Q represents nominal income or nominal GDP. Therefore, the equation shows that the quantity of money multiplied by its velocity must equal nominal income.

A (Velocity of demand multiplied by the number of times this money is spent in a given year must be larger than nominal income) YOUR ANSWER

This choice is incorrect because the equation of exchange does not use the term “velocity of demand.” In addition, the equation requires equality with nominal income, not a value larger than nominal income.

B (Quantity of money multiplied by the number of times this money is spent in a given year must be larger than nominal income) YOUR ANSWER

This option incorrectly states that the result must be larger than nominal income. According to the equation of exchange, the money supply multiplied by velocity is equal to nominal income.

C (Velocity of demand multiplied by the number of times this money is spent in a given year must equal nominal income) YOUR ANSWER

Although this choice correctly states that the relationship equals nominal income, it incorrectly uses the phrase “velocity of demand.” The correct concept is the velocity of money, which measures how frequently money circulates in the economy.

D (Quantity of money multiplied by the number of times this money is spent in a given year must equal nominal income) CORRECT

— Correct Answer
This choice correctly describes the equation of exchange. The quantity of money multiplied by the number of times it circulates in the economy equals nominal income.

Conclusion

The equation of exchange explains the relationship between the money supply, the velocity of money, and nominal economic output. It is a key principle in monetary theory and helps economists analyze inflation, economic activity, and the effects of changes in the money supply.

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