<p>Chapter 17, Problem 1</p> <p>Suppose that this year’s money supply is $
ID: 1252362 • Letter: #
Question
<p>Chapter 17, Problem 1</p><p>Suppose that this year’s money supply is $500 billion, nominal GDP is $10 trillion, and real GDP is $5 trillion.</p>
<ol>
<li>What is the price level?  What is the velocity of money?</li>
<li>Suppose that velocity is constant and the economy’s output of goods and services rises by 5 percent each year.  What will happen to nominal GDP and the price level next year if the Fed keeps the money supply constant?</li>
<li>What money supply should the Fed set next year if it wants to keep the price level stable?</li>
<li>What money supply should the Fed set next year if it wants inflation of 10 percent?</li>
</ol>
Explanation / Answer
Chapter 17, Problem 1 Suppose that this year's money supply is $500 billion, nominal GDP is $10 trillion, and real GDP is $5 trillion. What is the price level? The price level is (Nominal GDP/Real GDP), so (10/5)=2 What is the velocity of money? V=PY/M Where V is velocity, P is Price Level, Y is Real GDP V=10 trillion/.5 trillion=20 Suppose that velocity is constant and the economy's output of goods and services rises by 5 percent each year. What will happen to nominal GDP and the price level next year if the Fed keeps the money supply constant? Since MV=PY, and we are holding M and V constant, PY must stay constant. So, if Y (Real GDP) increases 5%, the price level will fall by 5%. Nominal GDP is PY, so it will stay the same. What money supply should the Fed set next year if it wants to keep the price level stable? Using the formula MV=PY again, if Velocity and Price Level are constant, and Y increases 5%, then M (Money Supply) will need to increase 5%...what happens to one side of the equation, must happen to the other. What money supply should the Fed set next year if it wants inflation of 10 percent? Assuming we are still holding Velocity constant and we still have a 5% increase in Real GDP, money supply needs to increase by 15% to balance the 5% and 10% increases on the other side of the equation. So, .15 of .5 trillion dollar money supply increase is .15*.5=.075 trillion, for a total money supply of .575 trillion, or 575 billion dollars.
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