Answer to Question 1
B
Answer to Question 2
The quantity theory of money is the proposition that in the long run an increase in the money supply leads to an equal percentage increase in the price level. The velocity of circulation is defined as the average number of times a dollar is used annually in exchange for goods and services. Because GDP is the total of all goods and services purchased, we can derive a formula for the velocity of circulation from GDP. If we use Y for real GDP and P as the price level, the PY = nominal GDP. Because the money supply is used to purchase GDP, velocity, V, equals (PY)/M, where M is the quantity of money. This formula can be rearranged to become the equation of exchange, which states that MV = PY. Given the assumptions that neither velocity nor potential GDP are influenced by the quantity of money, we can then solve for the price level as P = (MV/Y). Given the assumptions then, changes in the quantity of money lead to only changes in the price level. The quantity theory states that in the long run the percentage increase in the quantity of money equals the percentage increase in the price level.
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