Question

The money market is initially at equilibrium at
Y/V = M/P : Y =60, V= 10 and M = 120, P = 20
Suppose the economy experiences real growth of 5% and
inflation rises by 4% ; assume velocity of money holds constant.

How much should the CB raise the money supply to get the
money market back to equilibrium? and Why does the CB seldom succeed in getting the economy back
to monetary equilibrium quickly?

Answer 1

The money market is initially at equilibrium at Y/V = M/P : Y =60, V= 10 and M = 120, P = 20
Suppose the economy experiences real growth of 5% and inflation rises by 4% ; assume velocity of money holds constant. Hence Y rises from 60 to 60*(1.05) = 63, price level rises from 20 to 20*1.04 = 20.8. Velocity is same. Hence new money supply is 63/10 = M/20.8

M = 131.04

CB must raise the money supply by 11.04 from 120 to 131.04, to get the money market back to equilibrium.

CB seldoms succeed in getting the economy back to monetary equilibrium quickly due to lags in monetary policy which includes recognizing the problem late (recognition lags) as well as implementation lags.