Suppose that this year\'s money supply is $500 billion, nominal GDP is 18 trilli

Question

Suppose that this year's money supply is $500 billion, nominal GDP is 18 trillion, and price level is 3.

a) What is the real GDP? What is the velocity of money?

b)Suppose that velocity is constant and the economy's real GDP growth is 3% each year. What will happen to the price level and nominal GDP next year if the Fed increases the money supply by 5%?

c) What money supply should the Fed set next year if it wants to keep the price level stable?

d) What money supply should the Fed set next year if it wants inflations of 2%?

Explanation / Answer

MV = P x Y

a) Nominal GDP = $ 18 tn , P = 3

Real GDP (Y) = 18/3 = $ 6 tn

b) Increase in money supply = 5% , V is constant and real GDP (Y) incrases by 3% each year

P = (1 + 5%)/(1 + 3%) x 3 = 3.058

Price level increases by 1.94%

Nominal GDP = 3.058 x 6 = $18.35 tn

c) Price level would be stable if money supply also increases by the same rate as the real GDP i.e. 3% (such that, LHS = RHS)

Money supply = 500 x 1.03 = $515 bn

d) If P grows by 2% and real GDP grows by 3%:

Money supply should increase by : (1 + 2%) x (1 + 3%) - 1 = 5.06%

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