Suppose a country has a money demand function (Md/P) = kY where k is a constant

Question

Suppose a country has a money demand function (Md/P) = kY where k is a constant parameter. The money supply grows by 12 percent per year and real income grows by 4 percent per year.

a. What is the inflation rate?
b. How would inflation be different if real income growth were higher? Explain.
c. Suppose, instead of a constant velocity money demand function, the velocity of money in this economy was growing steadily because of financial innovation. How would that affect the inflation rate? Explain

Explanation / Answer

A.) 8% 12% money supply growth rate - 4% income growth rate B.) Inflation would be lower by 1% for each income growth rate% higher C.) That would cause inflation by increasing the demand for money and interest rate.

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