Question

Consider an economy made up of a butcher and a baker. Each period the butcher sells 4 pounds of meat to the baker for $5 each and the baker sells 10 loaves of bread to the butcher also for $2 each.

a. What is NGDP here?

b. If the money supply is $5, what is velocity?

c. Let us call the price level in this case 10. What does that make Y?  (Note that this is arbitrary.)

d. Now imagine that the money supply increases to $12. In the long run, what would you expect the following to be?

Y=

V=

P=

Answer 1

a) NGDP = ($5 * 4) + ($2 * 10) = $20 + $20 = $40

b) The quantity theory equation is:

MV = PY

Where, M = Money supply , V = Velocity of money, P = Price level, and Y = Real GDP

PY = Nomial GDP (NGDP)

5 * V = 40

V = 40 / 5 = 8

c) If P = $10

MV = PY

5 * 8 = 10 * Y

40 = 10Y

Y = 40 / 10 = $4

d) As we know the change in a nominal variable,(i.e. the money supply) leads to changes in other nominal variables, but real variables do not change. So, in the long run, changes in the money supply will have no effect on real variables. Thus, Y remains unchanged. So, when money supply increases to $12, the real GDP and velocity remains unchanged, Thus,

Y = $4

V = 8

MV = PY

12 * 8 = P * 4

96 = 4P

P = 96 / 4 = $24