Question

a) Write out the equation that describes the Quantity Theory of Money. Must indicate clearly what each variable in the equation means in order to earn full marks . Based on the equation, predict what would happen to inflation in the long run:

b). if the growth rate of the velocity of money is zero and money supply grows at a faster rate than real GDP growth rate. You may use some hypothetical numbers to illustrate your answer (1.5 marks)

c). if the growth rate of the velocity of money is zero and money supply grows at a slower rate than real GDP growth rate. Use some hypothetical numbers to show (1.5 marks) d). Based on these two scenarios (b and c) and the quantity theory of money as stated in this question, what would be a good monetary policy for the economy in the long run?

Answer 1

a) Quantity Theory of Money.

MV = PY

Here, M is the money supply; V is the velocity of money; P is the price level; Y is the real GDP

In the long run, the level of inflation depends on the growth rate of money supply minus the growth rate of real GDP.

That means, money creation should be proportional to GDP growth. Otherwise, only inflation will take place.

b) If the growth rate of the velocity of money is zero and money supply grows at a faster rate than real GDP growth rate

MV = PY       --   equation 1

Now, M grows at 10%, and GDP grows at 5%, V remains constant, P1 is the new price level.

Recall from equation 1, MV/Y = P

Thus,

In other words, there is inflation of about 4.8%.

c) If the growth rate of the velocity of money is zero and money supply grows at a slower rate than real GDP growth rate.

Recall from b), that

MV = PY       --   equation 1

Now, M grows at 5%, and GDP grows at 10%, V remains constant, P1 is the new price level.

Recall from equation 1, MV/Y = P

Thus,

In other words, there is deflation of about 4.6%.

d) Based on these two scenarios (b and c) and the quantity theory of money, what would be a good monetary policy for the economy in the long run?

The ideal monetary policy in the long run should involve changes in money supply as per the changes in real GDP.

This means, if real GDP grows, increase the money supply.

If real GDP shrinks, decrease the money supply.

This will ensure that inflation remains under control.