Question

Suppose that this year's money supply is $500 billion, nominal GDP is $10 trillion, and real GDP is $5 trillion.

The price level is _____, and the velocity of money is _____.

Suppose that velocity is constant and the economy's output of goods and services rises by 3 percent each year. Use this information to answer the questions that follow.

If the Fed keeps the money supply constant, the price level will (stay the same, rise by 3%, or fall by 3%) , and nominal GDP will (stay the same, rise by 3%,rise by 6%, fall by 6%, or fall by 3%) .

True or False: If the Fed wants to keep the price level stable instead, it should keep the money supply unchanged next year.

True

False

If the Fed wants an inflation rate of 11 percent instead, it should (decrease or increase)   the money supply by ____%. (Hint: The quantity equation can be rewritten as the following percentage change formula: (Percentage Change in M)+(Percentage Change in V)=(Percentage Change in P)+(Percentage Change in Y)Percentage Change in M+Percentage Change in V=Percentage Change in P+Percentage Change in Y.)

Answer 1

M x V = P x Y [and PxY = Nominal GDP]

% Change in M + % change in V = % Change in P + % Change in Y

(1) Plugging in values,

$500 billion x V = $10,000 billion (10 trillion)

V = 20

P = Nominal GDP / Real GDP = $10 trillion / $5 trillion = 2

(2) When Y increases by 3%,

% Change in M + % change in V = % Change in P + % Change in Y

0 + 0 = % Change in P + 3%

% Change in P = - 3%

Price level will fall by 3%.

Nominal GDP will stay the same [Since % Change in P + % Change in Y = % Change innominal GDP = 0]

(3) FALSE

To keep price level stable, Fed should increase money supply.

(4) When % Change in P = 11%,

% Change in M + 0 = 11% + 3%

% Change in M = 14%

Fed should increase money supply by 14%.