Assume an economy’s annual money velocity in circulation is 10.

Question

Assume an economy’s annual money velocity in circulation is 10. Please answer the following two questions: a. If the annual nominal GDP is $200 trillion, how much money supply are enough for money demand? In the view of monetarists (i.e. neoclassical view), if the annual economic growth rate is 5% What should be the money supply increasing rate to maintain a low inflation rate as 2%? (i.e. neoclassical view), if the annual economic growth rate is 5%, An increase on in the in the quantity of money would increase the aggregate demand and the curve would shift rightward. what should be the money supply increasing rate to maintain a low inflation rate as 2%?

Answer 1

Though I'm not sure what the correct answer is, the problem may be solved in steps, taking into consideration of a few key points, from the standpoint of the Federal Reserve, who is in charge of setting the nation's monetary policies.

 

Based on the first two data points, we know the current supply of money = $200T / 10 = $20T However, we know this is only the current supply and not the ideal level, therefore not the final answer.

 

The $200T GDP is the product of average price level multiplied by the total transactions in the economy, both of which are also determinants for the velocity of money. The higher the number of transactions and value of transactions in a given period, the faster the velocity of money. To grow the economy at 5%, and therefore at a faster pace than the growth of the rate of inflation, at 2%, the price level needs to be kept at low while increasing the number of transactions, or in other words, general economic activities. Once the economy begins to grow, as you have pointed out, the aggregate demand curve for money will shift toward the right, moving the equilibrium point up, while at the same time increasing the value of money and decreasing the price level, since these two factors have an inverse relationship. However, once the economy gains momentum, all else held constant, the Fed can artificially decrease the money supply, thereby the equilibrium point will travel upward along the demand curve to reach a higher value and again, lower price level.