Suppose that initially the money supply is 2 trillion, the price level equals 4,

Question

Suppose that initially the money supply is 2 trillion, the price level equals 4, the real GDP is 6 trillion in base-year dollars, and income velocity of money is 12. Then the money supply increases by 200 billion, while real GDP and income velocity of money remain unchanged.

a. According to the quantity theory of money and prices, calculate the new price level after the increase in money supply: __.

b. Calculate the percentage increase in money supply: __%

c. Calculate the percentage change in the price level: __%

d. The percentage changes in the money supply is (less than, greater than, or equal to) percentage changes in the price level.

Explanation / Answer

The quantity theory equation states that

MV = PY

Where, M = money supply

             V = velocity

             P = price level

             Y = real GDP

a) MV = PY

      P = MV / Y

    when money supply increases by 200 billion (or 0.2 trillion), new M = 2.2 trillion

    P = 2.2 trillion * 12 / 6 trillion

       = 4.4

Thus, the new price level after the increase in money supply is 4.4

b) percentage increase in money supply = (0.2 trillion / 2 trillion) * 100 = 10%

c) percentage change in the price level = (0.4 / 4) * 100 = 10%

d) The percentage changes in the money supply is equal to percentage changes in the price level.

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