Use the following information for the next 9 questions. You should draw a graph

Question

Use the following information for the next 9 questions. You should draw a graph that depicts the situation below and use your picture to answer the questions.

Assume that wages and prices are sticky and that we start at a long-run equilibrium. Assume that at this initial point, the growth rate of the money supply is 7%, the growth rate of the velocity of money is 2% and that the real economic growth rate is 4%.

Now assume that the Federal Reserve has decided to increase the growth rate of the money supply by 4% and that the Federal Reserve leaves the growth rate of the money supply at this elevated rate.

1. Now think about the point that the economy ends up at that is the new long-run equilibrium. What is the inflation rate?

Explanation / Answer

1.

According to quantity theory of money:

Growth rate of money supply + Growth rate of velocity of money = Real economic growth rate + Inflation rate

(7% + 4%) + 2% = 4% + Inflation rate

11% + 2% - 4% = Inflation rate

Inflation rate = 9%

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