Question

In the country of Wiknam, the velocity of money is constant. Real GDP grows by 5 percent per year, the money stock grows by 14 percent per year, the nominal interest rate is 11 percent and the real interest rate is 2%

1. In Wiknam if Real GDP growth slows what would you expect to happen to the inflation rate? Explain using the model why.

2. If Wiknam households expect higher inflation in the coming year, how might that effect Money Demand? How would that affect the real interest rate, the nominal interest rate and actual inflation? (hint: use the chart that links money, prices and interests rates)

Answer 1

At the given rates, growth rate of velocity is 0 and growth rate of prices or inflation rate = growth rate of money - growth rate of real GDP = 14% - 5% = 9%. Also nominal interest rate is 11% and real interest rate is 2% which again gives inflation rate of 9%.

a) If real GDP growth rate is reduced, and money supply growth rate is same, then inflation rate should rise. This is because the two are inversely related under the quantity theory:

inflation rate = growth rate of money - growth rate of real GDP

Lower growth rate of real GDP with unchanged growth rate of money implies higher inflation rate

b) Higher expected inflation will result in increasing the money demand because purchases will be preponed. This will increase the nominal interest rate as well as the actual inflation when aggregate demand is increased. Real interest rate would remain unchanged.