Question

Consider an economy with the following Money market information. Is the past year inflation rate was 4%, the output grew by 5%, and the nominal interest rate on non-monetary assets grew by 2.5%. Moreover, we know that the central bank of this economy increased the Money supply of economy by 6%. As an economist you know that the interest elasticity of Money demand of this economy is -0.2. However, you don’t have any information about the income elasticity of Money demand. You expect that the output of the economy is going to grow by 12%, and the nominal interest on non-monetary assets is going to grow by 20% in the current year. How much should the Central Bank change the Money supply so that the inflation rate is 6%?

Answer 1

We know that

Inflation rate = growth rate in the nominal money supply – income elasticity of money demand x GDP growth rate

4% = 6% - income elasticity of money demand x 5%

income elasticity of money demand = 2%/5% = +0.4

Now find the required change in money supply for current year so that the inflation rate is 6%

6% = growth rate in the nominal money supply - 0.4 x 12%

growth rate in the nominal money supply = 10.8%

In the current year money supply should be grown at 10.80 percent.