Question

Question 4. Please answer all three parts to this question. a. Write down the quantity equation, in both the level and the rates of change form. What do each of the terms represent? b. If the Bank of Canada wishes to maintain inflation at 2% per year, how can the bank use the quantity equation to achieve this goal? What assumption is made about the velocity of money? c. Does the Bank of Canada target the rate of growth of M1 (the money supply) or the inflation rate? Why?

Answer 1

a. We have the quantity equation of money, in both the level and the rates of change form:

P x Y = M x V

Price x real GDP = money stock * velocity of money

Nominal GDP = money stock * velocity of money

Price is general price level index and velocity of money is the speed at which a dollar bill is circulated or

changes hands.

And

Rate of inflation + Rate of growth of real GDP = Rate of growth of money supply + Rate of growth of velocity of

money

Rate of inflation + Rate of growth of real GDP = Rate of growth of money supply because velocity of money is assume to be constant.

b. If the Bank of Canada wishes to maintain inflation at 2% per year, it can use the quantity equation to achieve this goal by raising the money supply by a total of (real GDP growth rate + rate of inflation) or (2% + real GDP growth rate) . This is because the velocity of money does not change and so we have

Rate of growth of money supply = 2% + Rate of growth of real GDP.

c. Bank of Canada as well as the Federal Reserve Bank of the United States both are targeting target the inflation rate since past few decades. The money supply stock is not targeted because it is used as a tool to encourage a depressing economy or discourage an expanding economy. It is easy to control inflation using money stock but the opposite is not true.