Question

1. Suppose in the country A, the velocity of money in the country A is always stable. Answer the following questions: a. What is the quantity equation? (Please indicate and explain each variable) (2%) b. Suppose the price level in the period t-1 is Pt-1, and the price level in the period t is Pt in the country A. Please use Pt and Pt-1 to represent the inflation rate during the period t-1 and the period t in the country A. (2%) c. Suppose in the country A, the money supply was $2 million and real GDP was $4 million in 2005. In 2006, the money supply increased by 10 percent, real GDP increased by 5 percent and nominal GDP equaled $8.8 million. How much was the inflation rate between 2005 and 2006 in the country A? (Please use the percentage to represent your answer, and calculate to the second digit below, e.g. 0.456—0.46) (6%)

Answer 1

a) The quantity theory of money is explained by the following equation.
P * Q = M * V
Where,
P = Price Level or inflation in the economy.
Q = Quantity of goods produced in the economy
M = Money Supply in the economy
V = Velocity of Money or money turnover rate

The equation suggests that the value of total quantity of goods multiplied by the general price level should be equal to the money supply multiplied by the velocity of money in the economy.
The product of P*Q is nothing but the output or GDP so it indicates that the increasing money supply in the economy will result in increased inflation as well as GDP.

b) The quantity theory of money indicates the relation between money supply and inflation as well as output.
In the period t-1 we can write the equation as
Pt-1 * Q = M * V
In the period t we can have this equation as
Pt * Q = M * V

There is no information about changes in other variable over the period of time. In that case the price level will be same and inflation in that period will be zero.

c) P*Q = M*V
In 2005
P1 * 4 million = 2 million * V
In 2006
P2 * ( 4 million * 1.05 ) = ( 2 million * 1.10 ) * V
P2 * 4.2 million = 2.20 million * V

Dividing both equations
(P2/P1) * 1.05 = 1.10
P2 / P1 = 1.0476

(1.0476 - 1) * 100 = 4.76%