Question

) Suppose that this year’s money supply is $400 billion, nominal GDP is $1200 billion (or $1.2 trillion), and real GDP is $1000 billion.

a. What is the price level? What is the velocity of money?

b. Suppose that the velocity is constant and the economy’s output of goods and services rises by 5%. If the Fed keeps the money supply constant, what will happen to the price level?

c. Suppose again that velocity is constant and the economy’s output of goods and services rises by 5%. By how much must the Fed change the money supply to keep the price level constant?

d. Suppose again that velocity is constant and the economy’s output of goods and services rises by 5%. If the Fed wants 5% inflation, by how much should they change the money supply? Hint: don’t take shortcuts – this one is a little harder than the previous two.

Answer 1

a)

What is the price level? What is the velocity of money?

Equation :

M*V = P*Y

400*V = 1200

V = 1200/400

=3

Price level:

400*3 = P*1,000

P= 1200/1,000

= $ 1.2

b)

Suppose that the velocity is constant and the economy’s output of goods and services rises by 5%. If the Fed keeps the money supply constant, what will happen to the price level?

Price level shall decrease by 5 %. Rise in real output affects the nominal GDP and price level.

c)

Suppose again that velocity is constant and the economy’s output of goods and services rises by 5%. By how much must the Fed change the money supply to keep the price level constant?

There must be 5 % rise in money supply to keep the price level constant.

d)

Suppose again that velocity is constant and the economy’s output of goods and services rises by 5%. If the Fed wants 5% inflation, by how much should they change the money supply? Hint: don’t take shortcuts – this one is a little harder than the previous two:

There must be at least 5 % rise in money supply to keep price stable. Further, if we want to create inflation by 5 %, then 5 % extra money supply to be added.

Hence, Fed must increase money supply by 10 %.