s. Suppose this year\'s money supply is $500 billion, nominal GDP is $10 trillio
ID: 1157120 • Letter: S
Question
s. Suppose this year's money supply is $500 billion, nominal GDP is $10 trillion and real GDP is $5 trillion. (The calculations in this problem are simple - think about what they mean for an economy.) a) What is the velocity of circulation? What is the price level for this economy? b) Suppose the velocity is constant and the economy's output of goods and services rises by 5 percent next year. What will happen to nominal GDP and the price level next year if the Fed keeps the money supply constant? o What should the Central Bank make the money supply next year if it wants to keep the price level constant? (continue to assume V is constant) o) What should the Central Bank make the money supply next year if it wants inflation to be 10 percent? (continue to assume V is constant)Explanation / Answer
As per quantity equation,
M x V = P x Y, where M: Money supply, V: Velocity, P: price level, Y: real GDP, (P x Y): Nominal GDP
% Change in M + % Change in V = % Change in P (Inflation) + % Change in Y
% Change in M + % Change in V = % Change in Nominal GDP
(a) V = (P x Y) / M
$500 billion x V = $10 trillion = $10,000 billion
V = $10,000 billion / $500 billion
V = 20
(b) % Change in Y = 5%
% Change in M + % Change in V = % Change in P + 5%
0% + 0% = % Change in P + 5% [Since M and V are unchanged]
% Change in P = -5%
% Change in Nominal GDP = 0% + 0% = 0%
(c) % Change in P = 0
% Change in M + % Change in V = % Change in P + % Change in Y
% Change in M + 0% = 0% + 5%
% Change in M = 5%
Money supply should increase by 5%.
Money supply next year = $500 billion x 1.05 = $525 billion
(d) % Change in P = 10%
% Change in M + % Change in V = 10% + 5%
% Change in M + 0% = 15%
% Change in M = 15%
Money supply has to increase by 15%.
Money supply next year = $500 billion x 1.15 = $575 billion
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