Question

17. Consider two countries: Canada and the United States. The income elasticity of money demand is 0.5 and the nominal interest elasticity of money demand is -0.2 in both countries. In Canada, income (Y) grows at 6%, money supply (M) grows at 4% and the nominal interest rate (i) is constant at 3%. In the United states income (Y) grows at 2%, money supply (M) grows at 3% and the nominal interest rate () is constant at 2%. Which of the following statements is correct. (a) Canada will experience higher inflation rate than the United States because the growth rate of money is higher (4% versus 3%). (b) Canada will experience lower inflation rate than the United States. (c) Canada will experience a higher inflation rate because the nominal interest rate is higher than in the United States (3% versus 2%). (d) Canada will experience the same inflation rate as the United States.

Answer 1

According to the quantity theory of money.

M*V = P*Y

Where M is the money supply.

V is the velocity of money

P is the price level.

Y is real GDP.

In terms of % growth.

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

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Canada

% growth in M = 4

% growth in Y =6

% growth in V = 0 (velocity remains constant)

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

4 + 0 = % change in P + 6

% change in P = 4 -6

% change in P = -2.

There is an inflation rate of -2% in Canada

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United States

% growth in M = 3

% growth in Y =2

% growth in V = 0 (velocity remains constant)

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

3 + 0 = % change in P + 2

% change in P = 3-2

% change in P = 1.

There is an inflation rate of 1% in the United States.

The inflation rate in Canada is lower than the inflation rate in the United States.

Answer: Option (B)