Question

Velocity.   

a) The money supply is $600. The price level is 2 and Real GDP is 900. What is velocity?  

b) The money supply grows 3%, velocity is growing 1%, real output is growing 2%. What is the inflation rate? Suppose that people are worried that future inflation will be very high, so that people don’t want to hold onto money since it will lose value, which makes velocity grow at a rate of 10%. If the money supply continues to grow at 3% and RGDP continues to grow at 2%, what would be the inflation rate now?  

Answer 1

(a)

According to quantity theory of money we have :

MV = PY where M = money supply = 600, V = velocity of money, P = price level = 2 and Y = Real GDP = 900.

Thus using above equation we have :

MV = PY => 600V = 2*900 => V = 3

Hence, Velocity of money = 3

(b)

According to quantity theory of money we have :

MV = PY where M = money supply, V = velocity of money, P = price level and Y = Real GDP

Formula :

% change in (A*B) = % change in A + % change in B

=> % change in (M*V) = % change in (P*Y)

Using above formula we have :

% change in M + % change in V = % change in P + % change in Y

Here it is given that % change in M = 3%, % change in V = 1%, % change in Y = 2% and % change in P = Inflation rate that we have to find.

Thus we have :

3% + 1% = Inflation rate + 2% => Inflation rate = 2%

Hence, Inflation rate = 2%

Now, all else are same buy % change in V increases from 1% to 10%

Thus using above formulas we have :

% change in M + % change in V = % change in P + % change in Y

Now, we have % change in M = 3%, % change in V = 10%, % change in Y = 2% and % change in P = Inflation rate that we have to find.

=> 3% + 10% = Inflation rate + 2%

=> Inflation rate = 11%

Hence, Now Inflation rate = 11%