Question #3 3. In 2004, the economy was at full employment, with a real GDP of $

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Question #3

3. In 2004, the economy was at full employment, with a real GDP of $886 billion, a 6% nominal interest rate per annum, a 2% annual inflation rate, a 1.1 price level, and 10 velocities of circulation.

A. What was the real interest rate in this economy?

B. How did nominal interest rate change if the inflation rate went up to 4% while real interest rate does not change?

C. What was the “basic quantity equation of money” in this economy? From this relation, what is the equation for money supply (M)?

D. If potential GDP grew at 3% and quantity of money grew at 10%, (a) what was the long run rate of inflation, and (b) what was the velocity growth rate?

Explanation / Answer

A. Real interest rate = Nominal IR - Inflation = 6-2 = 4%

b. NIR = real IR + Inflation = + 4 = 8%

c. basic quantity equation of money, MV = PY

M = PY/V = 1.1. x 886 / 10 = 9.74

d. basic quantity equation of money for change in variables is written as-

Growth in money supply + Change in Velocity = Inflation + GDP growth

10 + dV = dP + 3

dP = 7+dV

dV = dP-7

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