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M Y Real money demand (i
M Y Real money demand (i.e., the demand for purchasing power) is given by where M is the quantity of money, P is the price level, Y is output, and i is the nominal ? 8i interest rate. AT THE BEGINNING OF THE YEAR, both borrowers and lenders expected inflation to be 3%. DURING the year, money supply increased by 7%, output increased by 5%, and the nominal interest rate increased by 2%. (a) How much was the percentage change in money velocity? (b) Calculate the actual inflation rate. (c) Is it true that purchasing power was transferred from borrowers to lenders?
Expert Solution
Please view explanation and answer below.
a) How much was the percentage change in the money velocity?
New velocity of money = 1.05 / 1.07 = 0.9813
Change in the velocity of money = 0.9813 – 1 = -0.0187
% change in the velocity of money = -1.87%
b) Calculate the actual inflation rate
Price level = (Money supply x velocity of money) / output = (1.07 x 0.9813) / 1.05 = 1.049991 x 1.05 = 0.99999 ≈ 1
The actual inflation rate is 0 since the price level didn’t change.
c) Is it true that purchasing power was transferred from borrowers to lenders?
True → since the expected inflation rate is higher than the actual inflation rate, the real interest rate earned by lenders is higher than expected. This increases the purchasing power of lenders and decreases the purchasing power of buyers.
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