Question

Suppose the demand for money in the country has the form (M/P)ᵈ=kY, where k is a constant. The money supply is growing at a rate of 12% per year and the real output is growing at a rate of 4% per year.

a) What will the average inflation rate?
b) If the growth rate of real output increases, how would it affect the rate of inflation?
c) Assume that the velocity of money is not constant, but starts increasing thanks to financial innovations. How does it influence the rate of inflation? Explain.

Answer 1

a) The average inflation rate is 8% per year. b) An increase in the growth rate of real output would decrease the rate of inflation. c) An increase in the velocity of money would increase the rate of inflation.

Step-by-step explanation:

a) To find the average inflation rate, we can use the quantity theory of money. The quantity theory of money states that the percentage change in the money supply plus the percentage change in velocity is equal to the percentage change in nominal GDP. Since velocity is not given, we can assume it is constant. Therefore, the average inflation rate is equal to the growth rate of the money supply minus the growth rate of real output. Given that the money supply is growing at a rate of 12% per year and real output is growing at a rate of 4% per year, the average inflation rate would be 8% per year.
b) If the growth rate of real output increases, it would lead to a decrease in the rate of inflation. This is because the percentage change in real output would be higher than the percentage change in the money supply, causing a decrease in the inflation rate.
c) If the velocity of money starts increasing thanks to financial innovations, it would lead to an increase in the rate of inflation. This is because an increase in velocity means that money is changing hands more frequently, which increases the effective money supply. As a result, there would be more money chasing the same amount of goods and services, leading to inflation.