Question

7.10 The money supply has increased by 10% over a period in which Y increased by 8% AND the interest rate has risen by 5% of what it was (e.g., from 20% to 21%). The income elasticity of money demand is 0.5, and the interest elasticity of money demand is –0.2. What has happened to the price level over this period?

Answer 1

Growth rate of Money supply =10%

Growth rate of output = 8%

Growth rate of interest = 5%

Income elasticity of money demand = 0.5,

Interest elasticity of money demand = –0.2.

Note that the rate of inflation = growth rate in the nominal money supply – growth rate in money demand.

a) Inflation rate = growth rate in the nominal money supply – income elasticity of money demand x Growth rate

of output + Interest elasticity of money demand x Growth rate of interest

growth rate = 10% - 0.5 x 8% + 0.2 x 5%= 7%

Hence, inflation rate has risen by 7%.