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The income elasticity of money demand is 4/5 while the interest elasticity is -0.2 (minus 20%). Real income is expected to grow by 2.5% over the next year, and the nominal interest rate is expected to grow by 20%.

a. What is the expected inflation rate if the Central Bank maintains the growth rate of the money supply at 4%?

b. The central bank wants to set the growth rate of the nominal money supply in order to attain a 4% expected inflation rate. What should that growth rate be?

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Yusra Anees
Yusra AneesLv10
28 Sep 2019

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Related questions

Consider the following demand equation for money.

(M/P)d = kY

a) In words, explain what the velocity of money is.

b) Let the supply of (real) money be given by M/P. Using the money demand equation, solve for the velocity of money.

c) Suppose that real GDP is expected to grow 3% over the next year and k is constant. What is the expected rate of inflation if the Fed holds the money supply constant?

d) Suppose that the Fed (Federal Reserve) targets inflation to be 2% over the coming year. What should be the targeted growth rate of the money supply?

e) Suppose that growth in real GDP ends up being 1%. Assuming the Fed carries out its open market operations, expecting a growth rate of 3%, what will happen to the rate of inflation?

f) Is there reason to think that demand for money should be a function of the nominal interest rate? Why?

g) Modify the money demand equation that is given to include the nominal interest rate.

Label each of the following statements true, false, or uncertain. Explain briefly.

1. The nominal interest rate is measured in terms of goods; the real interest rate is measured in terms of money.

2. As long as expected inflation remains roughly constant, the movements in the real interest rate are roughly equal to the movements in the nominal interest rate.

3. When expected inflation increases, the real rate of interest falls.

4. The nominal policy interest rate is set by the central bank.

Assume an economy with floating exchange rates, price level is 100, exchange rate is 20, money supply is 10 million. Then suddenly the central bank increases money supply with 100% and keeps money supply at that (higher) level permanently. Calculate real money supply (M/P) in the long run, nominal exchange rate in the long run and expected exchange rate. Describe what happens with nominal interest rate in the short run and in the long run and describe the development of the nominal exchange rate from short to long run.

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