4. Suppose that this year the money supply is $ 400 billion, nominal GDP is $12

Question

4. Suppose that this year the money supply is $ 400 billion, nominal GDP is $12 trillion, and Real GDP is $ 6 trillion. Assume that that velocity of money is constant and the economy’s output of goods and services (Real GDP) rises by 4 percent each year. (4 points)

a. What will happen to the nominal GDP and price level if the Fed increases the money supply by 10 percent the next year? What will be the inflation rate the next year?

b. Refer to the initial data. What money supply should the Fed set the next year if it wants an inflation rate of 2 percent?

c. Refer to the initial data, if the Fed wishes to have zero inflation rate the next year, constant, does the

zero- inflation goal require that the rate of money growth equal zero? Explain why.

d. What does the quantity theory indicate is the cause of inflation? Is the link between the growth rate of the money supply and the inflation rate stronger in the short-run or in the long-run?

Explanation / Answer

4)

P = 12/6

= $ 2

MV = PY

400*V = $ 2*6 Trillion

V = 12 /0.4

= 30

Velocity of money is 30

a)

Increase in money supply by 10 % means there would be 10 % rise in the nominal GDP. but price level will increase by 6 % ( 10 % - 4 %)

b)

Federal Reserve must increase money supply by 6 % if it wants to achieve the target of 2 % inflation.

c)

Zero inflation rate can not be achieved with zero money supply or growth. Since economy is growing at the rate of 4%, hence money supply must be equal to 4 % to accomplish the target of zero inflation.

d)

Since economy is growing at the 4 %, thus higher growth rate in money supply would cause inflation. Money growth rate above the 4 % would cause inflation. if growth rate of economy would fall to zero, the relationship between inflation and money supply will become stronger. it can occur in long run.

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