Answer to Question #192475 in Macroeconomics for known

Question

1. The equation of exchange is helpful for determining the effect of money supply changes on the price level. Use the equation of exchange to answer each of the following questions.

a) Real GDP grows at 3% and inflation is equal to 2%, but there is no change in velocity. What can you conclude about the change in the money supply?

b) Real GDP falls by 3% and there is no inflation, but the money supply grew by 5%. What is the implied change in velocity?

c) Real GDP increases by 3%, velocity does not change, and the money supply grows by 10%. What is the implied rate of inflation?

d) The money supply grows at 6%, velocity is constant, and inflation is 3%. What can you conclude about the rate of real GDP growth?

Answer 1

The Equation of Exchange

a) Real GDP is increasing at a rate of 3% per year, with inflation at 2%. What are the consequences of the change in money supply?

The speed of money is determined by how quickly (on average) dollar bills change hands in the economy. The formula is based on dividing nominal expenses by the sum of money, which is equal to the total economic stock: When the economy moves quickly, each dollar spent generates a significant amount of nominal GDP. We can see that if we multiply the amounts on both sides of this equation, we get the quantity equation, one of the most well-known economic expressions: The rate of money supply equals the price level of real GDP.

b) Real GDP falls by 3%; there is no inflation, but the money supply expands by 5%. What does it mean when you say there's a speed difference?

The long-term stability of the speed is based on the observed close relationship between changes in the money supply and changes in price levels. On the other hand, the speed is not consistent in the short term; it varies significantly between the two periods. The rate of change is likely to slow, but not the same rate as the amount of money available. As a result, the extent to which an inevitable increase in the money supply increases nominal GDP will be reduced. Bond prices fall as supply expands, resulting in higher interest rates. Higher interest rates accelerate the government's pace to increase its purchases to raise the price level and actual GDP.

c) Real GDP is increasing at a 3% annual rate, while the money supply increases at a 10% annual rate. What is the implied rate of inflation?

It would be a relatively simple macroeconomic course if speed remained constant. Nominal GDP is determined solely by the amount of money in circulation; nothing else is taken into account. There would be more speed in the case of money because, perhaps due to high interest rates, a smaller fraction of nominal GDP was held. If people held money worth 10% of nominal GDP, the speed would be 10.

d) The cash supply grows at a rate of 6% per year, with inflation remaining constant at 3%. What conclusions have you reached about the rate of real GDP growth?

Even if the money supply remains constant, the nominal GDP may fluctuate. Assume that the number of people shopping for government items is increasing. As a result, the overall demand curve shifts to the right, boosting real GDP and price levels (Schultz et al., 2016). If the velocity remained constant, this effect would be impossible to achieve. Because speed varies and is positively different from the interest rate, it implies that increased government purchases could drive aggregate demand and nominal GDP. The government borrows money by selling bonds to finance increased spending. Bond prices fall as supply expands, resulting in higher interest rates. Higher interest rates accelerate the government's pace to increase its purchases to raise the price level and actual GDP. When looking at macroeconomic behavior, we can't assume that the speed is constant, and we can't assume that the output is either. The extent to which the rate and actual GDP change both V and Y in the exchange variable equation, determine the impact of a change in the money supply on the price level in the short term.

References

Schultz, D., & Nitschke, J. R. (2006). Designing multistep transformations using the Hammett equation: imine exchange on a copper (I) template. Journal of the American Chemical Society, 128(30), 9887-9892.