Question

In the quantity theory, inflation does all of the adjusting. Recall that

M* + v* = Inflation + real growth.

a. Consider the nation of Kydland. Before the shock to Kydland’s economy, M* = 10%, v* = 3%, real growth = 4%. What is inflation?

Inflation is _____%

b. In Kydland, v* falls to 0%, but M* stays the same. In the long run, what will inflation equal? What will real growth equal?

Long-run inflation will be _____% Real growth will be _____%

c. Consider the nation of Prescottia. Before the shock to Prescottia’s economy, M* = 2%,v*⃗ = 4%, real growth = 2%. What is inflation?

Inflation is ____%

d. In Prescottia, v* rises to 8%. In the long run, what will inflation equal? What will real growth equal?

Inflation will be ____% Real growth will be ______%

e. Consider the nation of Friedmania. Before the shock to Friedmania’s economy, M* = 3%, v* = 0%, real growth = 3%. What is inflation?

Inflation is ______%

f. In Friedmania, M* falls to 1%. In the long run, what will inflation equal? What will real growth equal?

Inflation will be _______% Real growth will be ______%

Answer 1

In the quantity theory, inflation does all of the adjusting. Recall that M* + v* = Inflation + real growth.

a. Inflation = 10% + 3% - 4%

= 9%

Hence the inflation rate is 9%

b. Now v* falls to 0%, but M* stays the same. In the long run, inflation equal 10% - 4% = 6% and real growth rate will be same at 4%

c. Inflation = 2% + 4% - 2% = 4%

Hence the inflation rate is 4%

d. In the long run, real growth rate will be unchanged at 2%. Then all the change will be reflected in inflation rate.

Inflation will be 8% Real growth will be 2%

e. Inflation is 3% + 0% - 3% = 0%

Hence the inflation rate is 0%

f. Inflation will be -2% Real growth will be 3%