Complete Question
Suppose that the money demand function takes the form
(M/P)^d = L(i,Y) = Y/(5i)
a. If output grows at rate and the nominal interest rate is constant, at what rate will the demand for real balances grow
b. What is the velocity of money in this economy
Answer:
a. See explanation below
b. Velocity = 5i
Step-by-step explanation:
a. Suppose that the nominal interest rate remains constant, the demand for real balances will grow at the same rate at which the output grows.
b.
Given that (M/P)^d = L(i,Y) = Y/(5i)
Money equation is written as;
Total Spending = MV
Where M = Amount of Money..
V = Velocity of Circulation
Total Spending = PY;
So, PY = MV --- Make V the subject of formula
PY/M = V --- Rearrange
V = PY/M ---- (1)
Also,
M/P = Y/5i --- Cross Multiply
M * 5i = P * Y --- Make 5i the subject of formula
5i = PY/M ---- (2)
Compare 1 and 2
5i = V = PY/M
So, 5i = V
V = 5i
Hence, Velocity = 5i
