Question

Suppose that velocity of money is constant, the expected inflation rate is equal to the actual inflation rate, and the expected real interest rate is 4%. Answer the following questions. Justify your answers.

1. Does the quantity theory allow for money to be used for assets and risk diversification purposes?
2. When the growth rate of money supply is 7% and the growth rate of real GDP is 3%, what is the nominal interest rate?
3. Let the growth rate of money supply rise to 10% without affecting the growth rate of real GDP or velocity. What happens to the inflation rate? If this new inflation rate becomes the expected inflation rate what happens to the nominal interest rate?
4. Has the increase in the growth rate of money supply been generated by an open market operation conducted by the central bank as in exercise 2? If so how did the central bank generate this increase in the money supply? Only a qualitative answer is required.

Answer 1

a) Quantity theory of money states that money supply and price level in an economy are in direct proportion to one another. When there is a change in the supply of money, there is a proportional change in the price level and vice-versa. The quantity theory of money states that there is a direct relationship between the quantity of money in an economy and the level of prices of goods and services sold. ... So an increase in money supply causes prices to rise (inflation) as they compensate for the decrease in money's marginal value.It allows the money to be used in assets.A company lists its assets on its balance sheet. Common asset categories include cash and cash equivalents; accounts receivable; inventory; prepaid expenses; and property and equipment. ... Cash, short-term investments and inventory are examples of current assets.J

Diversification is a risk management strategy that mixes a wide variety of investments within a portfolio. ... The rationale behind this technique is that a portfolio constructed of different kinds of assets will, on average, yield higher long-term returns and lower the risk of any individual holding or security.A company may decide to diversify its activities by expanding into markets or products that are related to its current business. For example, an auto company may diversify by adding a new car model or by expanding into a related market like trucks. ... Another strategy is conglomerate diversification

b)Nominal interest rate refers to the interest rate before taking inflation into account. Nominal can also refer to the advertised or stated interest rate on a loan, without taking into account any fees or compounding of interest.

Nominal interest rate =(1+nominal interest rate/1+inflation rate)-1

=(1+7/100/1+3/100)-1

1+0.07/1+0.03=(1.07+1.03)-1=2.1-1=1.1%

c) If growth rate of money supply rise to 10% then it will have adverse effect in inflation rate also .The inflation rate in 2019 was 1.76%. The 2019 inflation rate is higher compared to the average inflation rate of 0.90% per year between 2019 and 2020. Inflation rate is calculated by change in the consumer price index (CPI). Expected inflation is the core consumer price index (CPI; all items less food and energy) forecast from a backward-looking Phillips curve in which actual inflation responds to its lagged quarterly average and to the Hodrick–Prescott detrended unemployment rate.In the long-term, the United States Inflation Rate is projected to trend around 1.90 percent in 2020, according to our econometric models.

GDP is measured by taking the quantities of all goods and services produced, multiplying them by their prices, and summing the total. GDP can be measured either by the sum of what is purchased in the economy or by what is produced. Demand can be divided into consumption, investment, government, exports, and imports.

d) In open operations, the Fed buys and sells government securities in the open market. If the Fed wants to increase the money supply, it buys government bonds. This supplies the securities dealers who sell the bonds with cash, increasing the overall money supply.The Federal Reserve (Fed) buys and sells government securities to control the money supply. This activity is called open market operations (OPO). ... To increase the money supply, the Fed will purchase bonds from banks to inject money into the banking system.When the Fed conducts open-market purchases, it buys Treasury securities, which increases the money supply. it buys Treasury securities, which decreases the money supply. ... it lends money to member banks, which decreases the money supply.

Central banks use several different methods to increase or decrease the amount of money in the banking system. These actions are referred to as monetary policy. While the Federal Reserve Board—commonly referred to as the Fed—could print paper currency at its discretion in an effort to increase the amount of money in the economy, this is not the measure used, at least not in the United States.The Federal Reserve Board, which is the governing body that manages the Federal Reserve System, oversees all domestic monetary policy. They are often referred to as the Central Bank of the United States. This means they are generally held responsible for controlling inflation and managing both short-term and long-term interest rates. They make these decisions to strengthen the economy, and controlling the money supply is an important tool they use.

Thekey examples includes

1.Central banks use several methods, called monetary policy, to increase or decrease the amount of money in the economy.

2.The Fed can increase the money supply by lowering the reserve requirements for banks, which allows them to lend more money.

3.Conversely, by raising the banks' reserve requirements, the Fed can decrease the size of the money supply.

4.The Fed can also alter short-term interest rates by lowering the discount rated that banks pay on short term loans from the FED