Question

Money supply = RM 500 billion, Nominal GDP = RM 10 trillion, Real GDP = RM 5 trillion.

A. What is the price level?

B. What is the velocity of money?

C. What will happen to nominal GDP and the price level on the next year if the economy’s output of goods and services rises 5%. (Assuming that velocity and the money supply are constant)

D. In order to keep the price level stable on the following year, What should the central bank do in regards to the money supply?

E. What should the central bank do in regards to the money supply on next year if it wants inflation of 10 percent?

Answer 1

According to Quantity theory of money (QTM)

MV = PY

Where M is money supply

V is the velocity

P is the price level

Y is the real GDP.

PY is the nominal GDP

Given information:

M = 500 billion = 0.5 trillion

PY = 10 trilion

Y = 5 tillion.

(A)

Nominal GDP = Price level * Real GDP

10 trillion = Price level * 5 trillion

Price level = 10 trillion / 5 trillion

Price level = 2.

(B)

MV = PY
0.5 trillion * V = 10 trillion

V = 10 trillion / 0.5 trillion

V = 20

Velocity of money is 20

(C)

MV = PY

It can be written in the form of growth rate:

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

% change in M = 0

% change in V = 0

% change in Y = 5

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

=> 0 + 0 = % change in P + 5

=> % change in P = -5

Hence, the price level will fall by 5%

Nominal GDP = Price level * real GDP

=> % change in nominal GDP = % change in Price level + % change in real GDP

=> % change in nominal GDP = -5 + 5

=> % change in nominal GDP = 0

Hence, the nominal GDP will remian unchanged.

(D)

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

% change in P = 0

% change in V = 0

% change in Y = 5

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

=> % change in M + 0 = 0 + 5

=> % chaneg in M = 5

Hence, money supply should raise by 5% in order to keep the price level stable.

(E)

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

% change in P = 10

% change in V = 0

% change in Y = 5

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

=> % change in M + 0 = 10 + 5

=> % change in M = 15

Hence, money supply should increase by 15% in order to keep inflation rate at 10%.