Question

1. Friedmania is a country in which the quantity theory of money operates. The country has a constant population, capital stock, and technology so real GDP does not change. In 2008 real GDP was S500 mllon, the price level, measured by the GDP deflator, was 150 and the velocity of circulation of money was 10. (Because the price level is measured by the GDP deflator, it must be divided by 100 before it is used in the equation of exchange.) In 2009, the quantity of money increased by 20 percent. a What was the quantity of money in 2008? b) What was the velocity of circulation in 2009? cWhat was the price level in 2009? 2. Define the balanced budget multiplier and explain how it works. In your answer, ignore any supply-side effects.

Answer 1

1/a).

Consider the given problem here the real GDP is “$500 million” in “2008”, the price level is given by “P=150/100 = 1.5” and the velocity of circulation of money is given by “10”, => “v=10”. So, the quantity of money equation is given by.

=> M*V = P*Y, => M*10 = 1.5*$500, => M*10 = 1.5*$500 million = $75 million. So, the money supply in “2008” is given by “M(2008) = $75 million”.

b).

Now, in “2009” the money supply increases by “20%”. Now, because the velocity of circulation is completely independent of change of money supply, => as “M” changes will not change the “V”, => “V” will remain same as before. So, the velocity of money in “2009” is given by “V(2009) = 10”.

c).

Now, from the quantity equation of money we get that “Y” and “V” will not change, => to main the identity if “M” increases implied “P” must increase with the same proportion. So, here as “M” increases by “25%”, => “P” must also increases by “25%”. SO, in “2009” the price level is given by “1.5*1.25 = 1.875”.

2).

Now, the budget balance multiplier explain that how much “Y” will increase if “G” and “T” increases by the same amount, => when the government budget is in balance. So, the product market equilibrium is given by.

=> Y = C(Y-T) + I + G, => dY = MPC*(dY - dT) + dI + dG, => (1-MPC)*dY = (-MPC)*dT + dG.

=> (1-MPC)*dY = (1-MPC)*dG, “dT=dG” and “dI=0”.

=> dY/dG = 1 > 0, => if “G” and “T” increases by the same amount implied the equilibrium level of “Y” increases by the same amount exactly equal to the change of “G” and “T”.