In Classical theory, a decrease in money supply leads to :

Question

Accepted Answer

The correct option is 1: Decrease in price level.

In Classical macroeconomic theory, the relationship between money supply and the price level is explained by the Quantity Theory of Money (QTM), often summarized by the equation $MV = PY$, where $M$ is the money supply, $V$ is the velocity of money, $P$ is the price level, and $Y$ is the real output (real GDP). The Classical school assumes a strict dichotomy between the monetary sector and the real sector (monetary neutrality). Furthermore, they assume that the economy operates at full employment, meaning real output ($Y$) is fixed in the long run, and the velocity of money ($V$) is constant. Therefore, any change in the money supply ($M$) must lead to a proportionate change in the price level ($P$). When the money supply ($M$) decreases, there is less money chasing the same amount of goods and services ($Y$), causing the general price level ($P$) to fall proportionally.

The incorrect option is 2: Increase in savings.
In Classical theory, savings and investment are determined by the real interest rate, not the money supply. A change in the money supply only affects nominal variables like the price level, upholding the principle of monetary neutrality.

The incorrect option is 3: Decrease in investment.
Investment, like savings, is a real variable determined by the real interest rate in the Classical model. While a decreased money supply might temporarily affect the nominal interest rate, it does not impact the equilibrium real interest rate or the level of investment in the long run.

The incorrect option is 4: Increase in price level.
An increase in the price level would occur if the money supply increased, according to the direct relationship established by the Quantity Theory of Money. A decrease in money supply must cause the price level to decrease.