Use the following information for the next 10 questions. You should draw a graph

Question

Use the following information for the next 10 questions. You should draw a graph that depicts the situation below and use your picture to answer the questions. Assume that wages and prices are sticky and that we start at a long run equilibrium. Assume that at this initial point, the growth rate of the money supply is 6%, the growth rate of the velocity of money is 5% and that the real economic growth rate is 4%. Assume that there is a drop in consumption and investment such that causes total spending growth to drop by 5%. Assume now that the Federal Reserve is going to try and counter this drop in consumption and investment through monetary policy, and that they increase the growth rate of the money supply by 9%.

1.After consumption and investment fall (and before Federal Reserve action), what is the inflation rate in your graph?

2.After Federal Reserve action, what is the growth rate of the velocity of money?

3.After Federal Reserve action, what is the real economic growth rate in your graph?

Explanation / Answer

The quantity theory of money indicates that MV = PY. This also implies that any percentage change in any of the variable affects the whole equation:

% in M + % in V = % in P + % in Y

Given that the growth rate of the money supply is 6%, the growth rate of the velocity of money is 5% and that the real economic growth rate is 4%, the inflation rate becomes:

6 + 5 = % in P + 4

% in P or inflation rate is = 7%

Total spending growth rate is the sum of the growth rate of the money supply (6%) and the growth rate of the velocity of money (5%), which is currently 11%.

A fall in total spending growth rate by 5% shifts the AD curve to the left and decreases the total spending growth rate from 11% to 6%. Before the Federal reserve action, with unchanged money supply growth rate, velocity of money falls to 0% so that the total spending growth rate remains at 6%.

a) Now with the growth rate of the money supply is 6%, the initial growth rate of the velocity of money is 0% and that the real economic growth rate has fallen to 2%, the inflation rate becomes:

6 + 0 = % in P + 2

Inflation rate falls from 7% to 4%.

b) With money supply growth increased from 6% to 9%, the growth rate in real GDP is reached at 3% and inflation rate has increased to 5%. SO velocity of money is increased to 1%.

c) As mentioned, grwoth rate of real GDP is 3%.

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