Question

Suppose a country has a money demand function (M/P )d 5 kY, where k is a constant parameter. The money supply grows by 12 percent per year, and real income grows by 4 percent per year.
a. What is the average inflation rate?

b. How would inflation be different if real income growth were higher? Explain.

c. How do you interpret the parameter k? What is its relationship to the velocity of money?

Answer 1

Answer:

Check the calculations below

Explanation:

A. 12%-4%=8%

B. If real income was higher, the inflation level would decrease subject to the consumers budget constraints. In other words, they will make the same amount of money but their purchasing power per dollar will increase.

C. In this case, an increase in money would cause the inflation rate to increase. If we think about the past and events such as hyperinflation, look at what the cause was. Governments were printing money to pay debts, which in turn was decreasing the value of their currency. In this case, people would get paid and run to the store to spend their money because their dollars today may only be worth 50 cents tomorrow or in some cases, the next hour. Therefore, our answer is if the velocity of money keeps growing, inflation will keep growing as well. These two variables are pro cyclical with each other meaning they move together.