Question

Suppose real GDP is forecasted to grow by 2.93%, the velocity of money has been stable, and the Fed announces an inflation target of 3.90%. What is the largest money growth rate the Fed could implement and still achieve its inflation target? Now suppose there is a mid-year revision of the GDP forecast that lowers the expected growth rate below 2.93%. Ceteris paribus, what impact will this lower growth rate have on the rate of inflation? Inflation can be either higher or lower than originally expected. Inflation will be higher than originally expected O Inflation will be the same as originally expected. Inflation will be lower than originally expected.

Answer 1

1) Correct answer: 6.83% The following information is given: Expected growth of GDP = 2.93% Velocity = constant Inflation target = 3.90% To determine the growth rate of money, use the Quantity Theory of money equation as follows: MV = PY AMAV = APAY (AM)(0) = 3.90+ 2.93% AM = 6.83% [Here, M is money supply, V is velocity, P is price, and Y is the real GDP]. 2) Correct option: Inflation will be higher than originally expected When the expected growth rate of GDP will be below 2.93% with mid-year revision, the inflation rate will be higher keeping other things constant.