# Money supply and inflation

Based on the quantity equation of exchange (with income velocity V constant) and the Fisher effect, what would be the appropriate percentage values for inflation, real GDP growth, and SHORT TERM nominal interets rates (i)? Assume 3% is the Yf (full employment) growth rate for the real GDP and the real SHORT TERM interest rate (r) is constant at 1%.

1) If Y = Yf, and %change of M (money supply) is 5%...

a) what is % GDP inflation

b) what is % GDP growth

c) nominal interest rate (i)?

2) If the Fed DECREASES money supply growth from 5% to 3%....

IN THE SHORT RUN...

a) what is % GDP inflation

b) what is % GDP growth

c) nominal interest rate (i)?

IN THE LONG RUN...

a) what is % GDP inflation

b) what is % GDP growth

c) nominal interest rate (i)?

3) to DECREASE money supply, should the Fed buy or sell Treasury securities? why.

#### Solution Preview

Real Interest Rate = Nominal Interest Rate - Inflation

The real interest rate is determined by savings and investment with no relation to money and inflation.

The Nominal Gross Domestic Product measures the value of all the goods and services produced expressed in current prices. On the other hand, Real Gross Domestic Product measures the value of all the goods and services produced expressed in the prices of some base year.

The quantity theory of money is the proposition that when real GDP equals potential GDP, an increase in the quantity of money brings an equal percentage increase in the price level.

Quantity theory states that

M V = PY

This leads to

m + v = p + y

where

m= growth rate of money

v= growth rate of velocity

p= growth rate of price = inflation

y= growth rate of output ( real GDP)

If velocity is constant v=0

Or

m = p + y

(If velocity is constant, we get approximately the growth rate of money equals the growth rate of prices (inflation) plus the growth rate of output)

1) If Y = Yf, and %change of M (money supply) is 5%.

If V constant, growth rate of M = inflation rate + real GDP growth rate

Real interest rate + inflation rate = Nominal interest rate

a) what is % GDP inflation

Growth rate of M (5%)= inflation ...

#### Solution Summary

The solution calculates inflation, real GDP growth rate, and SHORT TERM nominal interest rates, given Yf (full employment) growth rate for the real GDP and the real SHORT TERM interest rate, based on quantity equation of exchange (with income velocity V constant) and the Fisher effect.