Question

Suppose that this year's money supply is $500 billion, nominal GDP is $10 trillion, and real GDP is $5 trillion.

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 Fed keeps the money supply constant?
c. What money supply should the Fed set next year if it wants to keep the price level stable?
d. What money supply should the Fed set next year if it wants inflation of 10 percent?

Answer 1

The price level is 2 and the velocity of money is 4. If the Fed keeps the money supply constant and the economy's output increases by 5%, nominal GDP will also increase by 5%, and the price level will remain unchanged. If the Fed wants to keep the price level stable, it should set the money supply next year to be the same as this year, which is $500 billion. If the Fed wants 10% inflation, it should set the money supply next year to be $550 billion.

Step-by-step explanation:

a. To find the price level, we use the equation Money Supply x Velocity = Nominal GDP = Price Level x Real GDP. Therefore, Price Level = Nominal GDP / Real GDP = $10 trillion / $5 trillion = 2. The velocity of money can be found by rearranging the equation as Velocity = Nominal GDP / (Money Supply x Real GDP) = $10 trillion / ($500 billion x $5 trillion) = 4.

b. If the Fed keeps the money supply constant, but the economy's output increases by 5%, then next year's nominal GDP will also increase by 5% because Nominal GDP = Price Level x Real GDP. The price level will remain unchanged.

c. If the Fed wants to keep the price level stable, it should set the money supply next year to be the same as this year, which is $500 billion.

d. If the Fed wants inflation of 10%, it should set the money supply next year to be $550 billion. This can be found using the equation Price Level = Nominal GDP / Real GDP = ($550 billion x $5 trillion) / $5 trillion = 11.