Question

Chapter 20: Money Growth, Money Demand, and Modern Monetary Policy

Exercise 20.1

Suppose velocity stays constant at 2, while M2 increases from $5 trillion to $6 trillion in a single year.

1. What would happen to nominal GDP?
2. Using your answer in Part (a) above, suppose real GDP rose 3%. What would be the level of inflation?

Exercise 20.2

According to Irving Fisher, when velocity and output are fixed, the Quantity Theory of Money implies that inflation equals money growth. What does the Quantity Theory of Money imply for inflation in the long run in an economy with growing output and stable velocity?

Exercise 20.3

Describe the impact of financial innovation on the demand for money and velocity.

Exercise 20.4

Explain why we observed a fall in velocity of M2 during the financial crisis of 2007–2009.

Exercise 20.5

Countries A and B both have the same money growth rate of 10%. In both countries, real output is constant.

In Country A velocity is constant, while in Country B velocity has fallen. In which country will inflation be higher? Explain why

Answer 1

20.1

A.

With the given data based scenario, the nominal GDP will increase.

As per quantity theory of money,

M*V = P*Q = nominal GDP

when money supply is $5 Trillion and velocity is 2. then:

Nominal GDP = 5*2 = $10 Trillion

When M2 increases to $6 Trillion and velocity remains at 2.

New Nominal GDP = 6*2 = $12 Trillion

So, it can be sent that nominal GDP increases.

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B.

Let level of inflation = i

Increase in money supply = 6/5 -1 = 20%

Then, using quantity theory of money:

(1+ 20%)*(1+0%) = (1+i)*(1+3%)

i = (1+20%)/(1+3%) - 1

i = 16.5%

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20.2

In the long run, output will be at the level of potential level of output, then inflation rate will become directly proportional to the increase in money supply, provided velocity is constant. Since real GDP growth rate is real variable that will not change in the long run, so it is only the nominal variable that will change and it is price level and resulting inflation from it.

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20.3

Financial innovation will create new types of financial services, new markets to rotate funds and new ways to use money by the consumers. It will increase the demand for money as consumers have more alternative to spend and for that, they demand money. At the same time, new markets will facilitate bringing borrowers and lenders in that market at a platform. It will also facilitate increased levels of transactions of money and rate of money changing hands will increase. So, velocity of money also increases in the economy.

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