Question

Suppose the elasticity of money demand with respect to income is 2/3. If the money supply increases by 10% and output increases by 4.5%, while the real interest rate and the expected inflation rate are unchanged, then the price level increases by

A) 3%

B) 7%

C) 13%

D) 10%

Answer 1

Answer:

OPTION B: 7%

Reason:

Price elasticity = 2/3

= Percentage change in quantity.output/ percentage change in price

Since it is given that output increased by 4.5%

We can calculate the chnage in price level by putting this into th eformula of elasticity

2/3 = 4.5/x

x = 4.5/2*3

x = 6.75% or 7 % approximately

Hence, increase in price level is 7%