2. (10 points) The income elasticity of money demand is 4/5 while the interest e

Question

2. (10 points) The income elasticity of money demand is 4/5 while the interest elasticity is -0.2 (minus 20%). Real income is expected to grow by 2.5% over the next year, and the nominal interest rate is expected to grow by 20%. a. (5 points) What is the expected inflation rate if the Central Bank maintains the growth rate of money supply at 4%? b. (5 points) The central bank wants to set the growth rate of nominal money supply in order to attain a 4% expected inflation rate. What should that growth rate be?

Explanation / Answer

Given,

The income elasticity of money demand is 4/5

Interest elasticity is -0.2

Real income grow by 2.5%

Nominal interest rate expected to grow by 20%.i.e.0.2.

1. The Expected inflation rate is given by the equation = M / M - YY / Y. To get inflation equal to zero, the central bank should set money growth so that M / M = Y Y / Y = 4/5 x 0.025 = .02 = 2%.

Note - Interest elasticity isn't relevant, since interest rates don't change.

2.

To get 4% inflation the central bank should set money growth so that M / M = Y Y / Y = 4/5 x 0.04 = .032 = 3.2%.

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