15 . Problems and Applications Q1 Suppose that this year\'s money supply is $500

Question

15 . Problems and Applications Q1 Suppose that this year's money supply is $500 billion, nominal GDP is $10 trillion, and real GDP is $5 trillion. The price level is , and the velocity of money is . Suppose that velocity is constant and the economy’s output of goods and services rises by 5 percent each year. Use this information to answer the questions that follow. If the Fed keeps the money supply constant, the price level will , and nominal GDP will . If the Fed wants to keep the price level stable instead, it should next year. If the Fed wants an inflation rate of 10 percent instead, it should . (Hint: The quantity equation can be rewritten as the following percentage change formula:

Explanation / Answer

(1) Quantity equation is:

M x V = P x Y where M: Money supply, V: Velocity, P: Price level, Y: Real GDP (So, P x Y = Nominal GDP)

(i) Price level = Nominal GDP / Real GDP = $10 trillion / $5 trillion = 2

(ii) Velocity of money (V) = (P x Y) / M = $10 trillion / $500 billion = $10,000 billion / $500 billion = 20

(2)

% Change in M + % Change in V = % Change in P (Inflation) + % Change in Y

% Change in M = % Change in P (Inflation) + % Change in Y [Since velocity is constant, % Change in V = 0]

% Change in Y = 5% (Given)

(i) If money supply is constant, % Change in M = 0

0% + 0% = % Change in P (Inflation) + 5%

% Change in P (Inflation) = - 5%

Price level will Decrease by 5%.

Nominal GDP will remain unchanged.

(ii) If price level is constant, % Change in P = 0

% Change in M + 0% = 0% + 5%

% Change in M = 5%

Fed should Increase money supply by 5%.

(iii) If inflation = 10%, % Change in P (Inflation) = 10%

% Change in M + 0% = 10% + 5%

% Change in M = 15%

Fed should Increase money supply by 15%.

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