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Using the quantity theory of money, suppose that this year's money supply is $100 billion, nominal GDP is $1 trillion, and real GDP is $250 billion
Using the quantity theory of money, suppose that this year's money supply is $100 billion, nominal GDP is $1 trillion, and real GDP is $250 billion. (show all your work)
a. What is the price level? What is the velocity of money?
b. Suppose that velocity is constant and the economy's output of goods and services rises by 5 percent each year. What will happen to nominal GDP and the price level next year if the Bank of Canada keeps the money supply constant?
c. What money supply should the Bank of Canada set next year if it wants to keep the price level stable and real GDP has increased by 5 percent?
d. If real GDP has increased by 5% , what money supply should the Bank of Canada set next year if it wants inflation of 5 percent?
Expert Solution
Quantity theory of money = Money supply(M) * velocity of money(V) = Real GDP * Price level.(NominalGDP)
a) Velocity of money = Nominal GDP/ money supply
= 1 trillion/ 100 billion = 10
Price level = money supply * velocity of money/ real GDP
= 100*10/250
Price level = 4
b)Nominal GDP will remain same when the money supply and velocity of money is constant because both side of equation must be equal. In this case price level will decrease by 5 percent.
c) In order to keep price level same bank have to increase the money supply by 5 percent only then equation will remain equal.
d) If it wants to increase the inflation 10 percent and GDP 5% then bank should increase the money supply by 5 percent because price level has already increased by 5 percent.
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