Question

The income elasticity of money demand is 0.5 and the interest rate elasticity of money demand is -0.2. Real income is expected to grow by 4% over the next year and the real interest rate is expected to remain constant over the next year. The rate of inflation has been zero for several years. If the central bank wants zero inflation over the next year, it should choose _______% for the growth rate of the nominal money supply.

Answer 1

Answer: -

We have the following information

·         Income elasticity of money demand = 0.5

·         Interest rate elasticity of money demand = -0.2

·         Real income grows by 4% next year

·         Zero growth rate for inflation and zero growth real rate for interest

We know that from the quantity theory of exchange

% change in M + % change in V = % change in Price + % change in real income

% change in M + 0 = 0 + 4%

Hence the central bank should choose a growth rate of 4% for nominal money supply