The transaction demand for money is Md = kPY, where k is a constant, P is the price level and Y is real GDP. Real GDP rises by 10 per cent and the price level rises by 20 per cent. By what percentage does the transaction demand for money rise?
Answer & explanation
Correct answer: option 1
The correct answer is Option (1) → 32 per cent
Given:
Y rises by 10 per cent: Y becomes 1.1Y
P rises by 20 per cent: P becomes 1.2P
In Md = kPY, money demand is proportional to the product of P and Y, so their changes multiply; they are not added.
\( \displaystyle M^d_{new} = k(1.2P)(1.1Y) = 1.32\,kPY \)
Transaction demand rises by 32 per cent. Adding 10 and 20 gives 30, which misses the 2 per cent that comes from both rising together.
NCERT (2026-27): “Box 3.1: Demand and Supply for Money : A Detailed Discussion … An increase in nominal GDP implies an increase in the total value of transactions and hence a greater transaction demand for money from equation (3.1). Thus, in general, equation (3.1) can be modified in the following way” “Md T = kPY (3.3)” “where Y is the real GDP and P is the general price level or the GDP deflator. The above equation tells us that transaction demand for money is positively related to the real income of an economy and also to its average price level.” |