4. The monetary policy rule and the velocity of money Aa Aa The quantity equatio

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4. The monetary policy rule and the velocity of money Aa Aa The quantity equation shows that the product of the money supply (M) and the velocity of money (V) is equal to the product of the price level (P) and real GDP (Y): M x V Px Y follow a monetary policy rule to ensure that the money supply (M) grows at a certain rate over time. They argued that the translate into steady growth of nominal GDP (P x Y). To see why this could be the case, consider the fact that any time the left-hand side of the quantity equation, M x V, changes by a certain percentage, the right-hand side, P x Y, must change by the same percentage argued that the central bank should was slow to change and predictable, so constant growth of the money supply would Percentage Change in (M x V) -Percentage Change in (PX Y) You can use a general rule about percentage changes to analyze changes in the variables of the quantity equation even further. The percentage change in the product of two variables is approximately equal to the sum of the percentage changes in each of the variables (as long as the percentage changes are fairly small). In the following equation, let "%A" stand for "percentage change in". For example, if you know that the money supply grows at a rate of 8% per year, velocity grows at a rate of 1% per year, and real GDP grows at a rate of 5% per year, you can use this rule to determine that the percentage change in the price level is equal to 4% (96 + %-%Y-%P) Suppose the central bank subscribes to a monetarist approach to monetary policy. The central bank believes that the velocity of money grows at a predictable rate of 196 per year and that potential real GDP grows at 3% per year. If the central bank observes a monetary policy rule that stipulates money supply growth of 4% per year, it will expect an inflation rate of per year and nominal GDP growth of per year Suppose that actual growth in the velocity of money unexpectedly falls to 0.5%. If the central bank continues to adhere to money supply growth of 4% per year and potential real GDP continues to grow at 3% per year, the inflation rate will be than anticipated, and nominal GDP growth will be than anticipated Which of the following events undermined the traditional monetarist case for a monetary policy rule based on money supply growth?

Explanation / Answer

1. Monetarist

2. Velocity of Money

3. Inflation rate of 2%

4. Nominal GDP 5%

5. Lower

6. Lower

7. Erratic changes in the growth of potential Output in 1970

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