Question

Suppose that this year’s money supply is $400 billion, nominal GDP is $10trillion, and real GDP is $4 trillion.

1.What is the price level? What is the velocity of money?

2. Suppose that velocity is constant and the economy’s output of goods and services rises by4% each year. What will happen to nominal GDP and the price level next year if the Fed keeps the money supply constant?

3.What money supply should he Fed set next year if it wants to keep the price level stable?

4.What money supply should the Fed set next year if it wants inflation of 10%?

Answer 1

The symbols used are:

Money supply = M

Velocity of money = V

Price level = P

Real GDP = Y

1) Nominal GDP = P * Y = 10 trillion

Real GDP (Y) = 5 trillion

So,

P * 5 trillion = 10 trillion

P = 10 trillion / 5 trillion = $2

The quantity theory equation is,

MV = PY

V = PY / M = 10 trillion / 400 billion = 10,000,000,000,000 / 400,000,000,000 = 25

Thus, the price level is $2 and the velocity of money is 25.

2. If V and M remains constant and Y rises by 4% , P must decrease by 4%, so that the equation MV = PY will be correct. The nominal GDP will be unchanged.

3. If the FED wants to keep the price level stable, it must increase the money supply by 4%.

4. If FED wants the inflation to be 10% for next year, it would increase the money supply by 14%. It means, M*V will rise by 14% causing P * Y to rise by 14% (i.e., 10% increase in price level and 4% increase in real GDP.