Question

Suppose that the nominal interest rate is 4.2%, the real interest rate is 2.8%, real GDP grows at 1%, and this year's money supply is $11.438B. To the nearest million, the size of next year's money supply will be $________B.

Answer 1

real Interest rate = Nominal Interest rate - inflation rate

2.8% = 4.2% - inflation rate.

Inflation rate = 4.2% - 2.8%

Inflation rate = 1.4%

=> % change in price level = 1.4

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Equation of Exchange

MV = PY

Where M is the money supply.

V is the velocity

P is the price level

Y is the real GDP.

In terms of growth:

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

The velocity is assumed to be constant. So, % change in V = 0

% change in P = 1.4 (Because inflation rate is 1.4%)

% change in Y =1 (Because real GDP grows at 1%)

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

% change in M + 0 = 1.4 + 1

% change in M = 2.4%

Hence the money supply will rise by 2.4% next year.

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Money supply = $11.438 Billion = $11438 million

Money supply next year = $11438 million (1 + 0.024)

Money supply next year = $11438 (1.024)

Money supply next year = $11712.512 million

Money supply next year = $11713 million

Money supply nect year = $11.713 billion.

Answer: $11.713 Billion.