Question

Suppose a country has a money demand function Md = 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?

d. Suppose, instead of a constant money demand function, the velocity of money in this economy was growing steadily because of financial innovation. How would that affect the inflation rate? Explain.