Question

5. Velocity and the equation of exchange Consider a simple economy that produces only pens. The following table contains information on the economy's money supply, velocity of money, price level, and output. For example, in 2014, the money supply was 50, the price of a pen was $4.00, and the economy produced 250 pens. Fill in the missing values in the following table, rounding to the nearest cent when necessary. Price Level Nominal GDP Money Supply (Dollars) Quantity of Output (Pens) Year Velocity of Money (Dollars) (Dollars) 2014 50 4.00 250 2015 51 20 250 The money supply grew at a rate of % from 2014 to 2015. Since pen output did not change from 2014 to 2015 and the velocity of money the change in the money supply was reflected in changes in the price level. The inflation rate from 2014 to 2015 was %

Answer 1

(I)

M x V = P x Y where (P x Y): Nominal GDP

(a) 2014:

(1) V = (P x Y) / M = (4 x 250) / 50 = 20

(2) Nominal GDP = 4 x 250 = 1,000

(b) 2015:

(1) P = (M x V) / Y = (51 x 20) / 250 = 4.08

(2) Nominal GDP = M x V = 51 x 20 = 1,020

(II)

(a) Money supply grew at 2% [= (51/50) - 1 = 1.02 - 1 = 0.02 = 2%].

(b) Since velocity stayed the same, change in money supply was reflected completely (fully) in changes in price level.

(c) Inflation rate was 2% [= (4.08/4) - 1 = 1.02 - 1 = 0.02 = 2%].