Question

Topic: Monetary Policy
Suppose that an economy is characterized by M = $2 trillion; V = 2.5; P = 1.0;
You are required to answer the following Questions:
1) What is the real value of output (Q)?
Now assume that the Fed increases the money supply by 10 percent and velocity remains unchanged.
2) If the price level remains constant, by how much will real output increase?
3) If, instead, real output is fixed at the natural level of unemployment, by how much will prices rise?
4) By how much would V have to fall to offset the increase in M?

Answer 1

M x V = P x Q

(1)

Q = (M x V) / P = (2 x 2.5) / 1 = $5 trillion

(2)

% Change in M + % Change in V = % Change in P + % Change in Q

10% + 0% = 0% + % Change in Q

% Change in Q = 10%

% Change in Q = $5 trillion x 10% = $0.5 trillion = $500 billion

(3)

% Change in M + % Change in V = % Change in P + % Change in Q

10% + 0% = % Change in P + 0%

% Change in P = 10%

% Change in P = 1 x 10% = 0.1

(4)

% Change in M + % Change in V = % Change in P + % Change in Q

10% + % Change in V = 0% + 0%

% Change in V = - 10%

% Change in V = 2.5 x 10% = 0.25%