Consider an economy whose key variables are modeled by the dynamic quantity theo
ID: 1112774 • Letter: C
Question
Consider an economy whose key variables are modeled by the dynamic quantity theory of money. Suppose money supply growth is currently at 4%, and output growth at full employment is 3%. Velocity is growing at 1%. Now assume that that businesses believe that the profitability of capital investments over the coming years is expected to be low and this discourages their willingness to carry out investment expenditures and also results in a widespread scaling back on production. As a result output growth falls to 2%, and the resulting situation also produces disinflation of 0.5%. 2. Consider the dynamic quantity theory of money; explain how equality is established in this setting, justifying how that concurs with the events just described.
Explanation / Answer
We have the following information
money supply growth is currently at 4%,
output growth at full employment is 3%.
Velocity is growing at 1%.
This implies that inflation rate is 4% + 1% - 3% = 2%.
Now assume that that businesses believe that the profitability of capital investments over the coming years is expected to be low. As a result output growth falls to 2%, and the resulting situation also produces disinflation of 0.5%. This would imply that now we have
% change in price + % change in output = 2% - 0.5% = 1.5%. While % change in money supply + % change in velocity is = 4% + 1% = 5% unchanged. Hence there is an inequality
With lower price level, money supply will increase in real terms and this would reduce the rate of interest. Production will increase and so output growth rate will increase along with inflation.
Since velocity grows at the same rate, this would increase % change in price + % change in output from 1.5% to 5% as it was initially.