In the Kingdom of Westeros suppose money supply is $0.5 million, nominal GDP is $10 million,...

In the Kingdom of Westeros suppose money supply is $0.5 million, nominal GDP is $10 million, and real GDP is $5 million during this year.

Calculate the price level and the velocity of money for Westeros this year.
Suppose velocity is constant and the Westerosi economy grows in real terms by 5% next year. What will happen to nominal GDP and the price level if the central bank in Westeros keeps the money supply constant? Please explain your answer briefly.
If the central bank wants to keep the price level stable in Westeros, what should it do to money supply instead? Please state clearly how much money supply would need to change and explain your answer briefly.
If the Westerosi central bank wants to have an inflation of 2% (rather than keep prices stable), how should it set money supply? Please explain your answer briefly.

Expert Solution

Price level = Nominal GDP/real GDP = 10/5 = 2

According to quantity theory of money, MV = PY where M is money supply, V is velocity of money, P is price level and Y is real GDP. Then 0.5*V = 2*5 => V = 10/0.5 = 20

Real GDP next year = 5*1.05 = $5.25 million and 0.5*20 = P*5.25 => P = 1.90 and Nominal GDP = PY = 1.90*5.25 = $10 million. Nominal GDP remains unaffected because the term MV is constant. However price and real GDP have changed.

If price level is kept constant, then M*20 = 2*5.25 => M = $0.525 million. This means for keeping price stable, money supply has to be increased by $0.025 million.

2% inflation means price will be 2*1.02 = 2.04 next year. Then M*20 = 2.04*5.25 => M = $0.5355 million. This means money supply has to be further increased to $0.5355 million. This is because money supply has direct relation with price level, other things being constant.

Rahul Sunny answered 7 months ago

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