Question

Suppose the economy has one good: candy bar. The real GDP is 1,000 candy bars, velocity is constant over years. In 2016, the money supply is $1,500, price level is $1.5 per candy bar.

In 2017, the Fed manipulates open-market operations to increase the money supply by 10%.

a. Compute the 2017 values of nominal GDP and price. Compute the inflation rate for 2016–2017.(In part a, assume the real GDP does not change)

b. Suppose the real GDP increases from 1,000 to 1,025 candy bars, compute 2016-2017 inflation rate.

Answer 1

(a)

In 2016,

Real GDP = 1,000 candy bars * $1.5 per candy bar = $1,500

Nominal GDP = 1,000 candy bars * $1.5 per candy bar = $1,500

GDP deflator = (Nominal GDP/Real GDP) * 100 = ($1,500/$1,500) * 100 = 100

In 2017, money supply increases by 10%. There is direct relationship between change in money supply and change in price level.

So, this increase in money supply by 10% will increase the price level by 10% as well

Price in 2017 = 1.5 + (1.5 * 0.10) = 1.5 + 0.15 = 1.65

Nominal GDP = 1,000 * 1.65 = $1,650

Real GDP = 1,000 * 1.50 = $1,500

GDP deflator = (Nominal GDP/Real GDP) * 100 = ($1,650/$1,500) * 100 = 110

Thus,

The price level in 2017 is $1.65 per candy bar.

The nominal GDP is $1,650.

Calculate inflation rate for 2016-2017

Inflation rate = [(GDP deflator in 2017 - GDP deflator in 2016)/GDP deflator in 2016] * 100

Inflation rate = [(110 - 100)/100] * 100 = 10%

The inflation rate for 2016-2017 is 10 percent.

(b)

In 2017, Real GDP increases from 1,000 to 1,025 candy bars.

Price in 2017 = 1.5 + (1.5 * 0.10) = 1.5 + 0.15 = 1.65

Nominal GDP = 1,025 * 1.65 = $1,691.25

Real GDP = 1,025 * 1.50 = $1,537.50

GDP deflator = (Nominal GDP/Real GDP) * 100 = ($1,691.25/$1,537.50) * 100 = 110

Calculate inflation rate for 2016-2017

Inflation rate = [(GDP deflator in 2017 - GDP deflator in 2016)/GDP deflator in 2016] * 100

Inflation rate = [(110 - 100)/100] * 100 = 10%

The inflation rate for 2016-2017 is 10 percent.