Question

1. Using the quantity theory of money explain how the Friedman Rule is obtained and its role for inflation stability.

2. Given the following Cobb-Douglas production function, Y = ALαK(1-α ), demonstrate how you would show (using Excel logic) that increases in labor cause an increase in output but at a decreasing rate.

Answer 1

According to quantity theory of money MV=PY

where M=money supply, V=velocity of circulation, P=price level, Y=national income

Increase in the money supply leads to inflation as in the short run velocity is fixed and output is also fixed. According to Milton Friedman, inflation is a monetary phenomenon because it can be produced only by a more rapid increase in the quantity of money than output. Friedman argues that money supply should rise by a fixed k% each year depending on institutional factor and independent on policymakers. The k percent rule regulates how much the money supply grows, thereby keeping inflation in check. That is it ensures economic stability.