In Freedonia the real demand for money is L = (M/P)d = kY, k a constant. The money supply is growing at 12% per year and real income, Y, is growing at 4% per year.
(a) What is the income velocity of money in Freedonia?
(b) What is Freedonia’s annual inflation rate?
(c) Suppose the income velocity of money is growing at the rate of 1%. What is Freedonia’s annual rate of inflation.
(a) By quantity theory of money we know that MV=PY or V=PY/M where V is velocity.
given M/P=kY or P/M=1/kY. Thus V=Y/kY=k. Thus velocity is k
(b) In growth terms quantity theory of money can be written as %change in money+%change in velocity=%change in price + %change in output
The money supply is growing at 12% per year and real income, Y, is growing at 4% per year. Suppose %change in velocity is zero, then
Inflation=%change in price=%change in money supply-%change in output=12-4=8%
(C) Suppose the income velocity of money is growing at the rate of 1%.
Inflation=%change in price=%change in money supply+%change in velocity-%change in output=12+1-4=9%
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