Question

Suppose that money supply is $4 trillion, nominal GDP is $20 trillion, and real GDP is $16 trillion. a. What is the price level? What is the velocity of money?

Suppose that velocity is constant and the economy’s output of goods and services rises by 3 percent each year.

b. What will happen to nominal GDP and the price level next year if the Fed increases the money supply by 5 percent?

c. What money supply should the Fed set next year if it wants to keep the price level stable? d. What money supply should the Fed set next year if it wants inflation of 1.5 percent?

5. The follow

Answer 1

(a) Using equation of exchange,

M x V = P x Y where M: Money supply, V: Velocity, P: Price level, Y: Real GDP and (P x Y) = Nominal GDP

(i) $4 trillion x V = $20 trillion

V = 5

(ii) $20 trillion = P x $16 trillion

P = 1.25

(b) In % terms,

% Change in M + % Change in V = % Change in P + % Change in Y = % Change in Nominal GDP

(i) 5% + 0 =  % Change in Nominal GDP

% Change in Nominal GDP = 5%

(ii) 5% + 0 =  % Change in P + 3%

% Change in P (Inflation) = 5% - 3% = 2%

(c) When price level is stable, % Change in P = 0.

% Change in M = 0% + 3%

% Change in M = 3%

(d) % Change in M = 1.5% + 3%

% Change in M = 4.5%