Question

He Fed increased the supply of US dollars at an average rate of 6 percent per year over the 1980-2005 period. Based on the theory of production capacity, if the Fed had instead increased the money supply at the rate of 7 percent per year during that period, given other policies.
A. The average inflation rate during 1980-2005 would have been one percentage point higher than it actually was in that period.B. The economy would have enjoyed a much higher level of output in the mid-2000s.C. The price level in 2005 would have been about 28 percent higher than what it actually reached in that year.D. The output of the economy in the mid-2000s would not have been very different from the levels it actually reached.

Answer 1

Answer:

B. The economy would have enjoyed a much higher level of output in the mid-2000s.

Explanation:

This choice is based on the theory of production capacity, which tries to explain that industrial capacity of companies increases with increased supply of production resources.  Capital is one of the production resources which is increased with increased supply of US dollars.  Increased money supply increases the capital which banks can lend out to companies to increase their production capacity.

On the other hand, where this to be based on the theory of inflation, a different answer would have been produced.  The theory of inflation recognizes that the average inflation rate increases proportionately to a percentage increase in money supply, among other factors that influence inflation rates.

That the price level in 2005 would have been about 28 percent higher than what it actually reached in that year is highly speculative.  And D is certainly not the correct option, because the economy's output is increased with increased production capacity caused by increased money supply.

Answer 2

Answer: A. The average inflation rate during 1980-2005 would have been one percentage point higher than it actually was in that period.

B. The economy would have enjoyed a much higher level of output in the mid-2000s

Explanation:

If the Fed increased money supply at a 1% rate higher than it had, then average inflation would have been higher than it actually was. This is because an increase in money supply leads to a rise in inflation simply because there is more money in the economy so people are able to buy more goods and services. As they do so prices would have to rise to match this demand.

Also the Economic output of the US would have been high in the mid-2000s due to the cumulative effects of a high money supply in the previous years. This is because firms would have had to match the growing demand for goods and services by expanding their production capacity. With a higher money supply, the cost of borrowing will be less so firms would easily be able to borrow money to finance their expansion and meet the said demand thereby raising the level of economic output.