Question

3. Suppose that real GDP in 2017 was $250 million (measured in base year dollars) and nominal GDP in 2017 was $375 million (measured in current year dollars) in a small country. The money supply during this period was $125 million. a. Suppose that the money supply increased to $130 million in 2018. According to the Quantity Theory, what will the price level be in 2018 as a result of the money supply increase, all else equal? Also, what will the inflation rate be from 2017 to 2018? b. Suppose that real GDP decreased to $235 million in 2018. If the central bank wanted the inflation rate to be 2 percent in 2018, what money supply would it target?

Answer 1

Solution:

Quantity theory of money states that: M*V = P*Q

Where M is money supply, V is velocity of money, P is price level and Q is real GDP

So, P*Q makes up the nominal GDP.

Given the information, we can calculate price level as:

P = nominal GDP/real GDP

P = 375/250 = $1.5

And the velocity of money as: V = P*Q/M

V = 375/125 = 3

a) With money supply, M = $130, and real GDP and velocity being unchanged:

P = M*V/Q

P = 130*3/250 = $1.56

Inflation rate = (price in 2018 - price level in 2017)*100/price level in 2017

Inflation rate = (1.56 - 1.5)*100/1.5

Inflation rate = 4%

b) For inflation to be 2%, price level in 2018 will be:

Price in 2018 = price in 2017*(1 + inflation rate)

Price in 2018 = 1.5*(1 + 0.02) = 1.53

Now, money supply in 2018, M = P in 2018*Q in 2018/V

M = 1.53*235/3 = 119.85

So, money supply to be targetted is $119.85 million