Question

If real GNP is expanding at a steady annual rate of 2 percent and the nominal money stock at a steady annual rate of 5 percent, what is the effect on the average price level if the income velocity of circulation of money is unchanged?

Short answer

The average price level will experience a 3% annual growth, leading to inflation. This is due to the growth in the nominal money supply (5%) outpacing the growth of real GNP (2%), while the income velocity of circulation remains unchanged.

Step-by-step solution

Understand Given Values

We are given the following: -Growth rate of real GNP (Y): 2% annually -Growth rate of nominal money supply (M): 5% annually -The income velocity of circulation (V) is unchanged.

Apply the Quantity Theory of Money

According to the Quantity Theory of Money (QTM), for a given unchanged income velocity \(V\), changes in the nominal money supply \(M\) would give rise to proportional changes in the monetary value of output \(PY\) if quantity equation holds true. The monetary value of output in turn depends on real output \(Y\) and the price level \(P\). This is expressed by the equation \(MV = PY\). Given that \(V\) is constant and assuming the quantity equation to hold true, any percentage change in \(M\) should be equal to the percentage changes in \(PY\).

Calculate the Rate of Inflation

The rate of inflation is calculated by subtracting the growth rate of real output (Y) from the growth rate of the money supply (M). Inflation rate = Growth rate of money supply - Growth rate of real output = 5% - 2% = 3%.

Analyze the Effect on Average Price Level

The inflation rate of 3% implies that the average price level would grow by 3% annually. This indicates an inflationary effect. That is, if the growth of the money supply outpaces the growth of real output and the velocity of money doesn't change, we will have an increase in the average price level, leading to inflation.

Key concepts

Quantity Theory of Money

The Quantity Theory of Money (QTM) is a fundamental concept used to explain the relationship between money supply and overall economic activity. It is based on the equation \(MV = PY\), where:

• \(M\) represents the nominal money supply.
• \(V\) is the velocity of money, which indicates how often a unit of currency is used for transactions within a given period.
• \(P\) stands for the price level, showing the average level of prices in an economy.
• \(Y\) is the real Gross National Product (GNP), reflecting the actual output of goods and services produced.

In simple terms, QTM suggests that an increase in the money supply will lead to a proportional increase in the product of the price level and real output, assuming the velocity of money remains constant. This theory helps us understand the potential impact of changes in money supply on inflation and economic output.

real GNP

Real GNP is an important measure of the economic health of a country. It calculates the total value of all final goods and services produced within a country's borders over a specific time period, adjusted for inflation. This adjustment is crucial because it allows for a comparison across different time periods by removing the effects of price level changes.
A rising real GNP indicates that the quantity of goods and services produced is growing, which is often taken as a sign of a healthy and expanding economy. Conversely, a decline may suggest economic downturns.

• A steady 2% increase in real GNP, as in our exercise, signals consistent production growth.
• This growth contrasts with nominal figures, providing a clearer picture of economic progress.

Understanding real GNP helps in assessing the real income and standard of living within an economy, separate from inflationary effects.

nominal money supply

The nominal money supply refers to the total amount of money in circulation within an economy, not adjusted for inflation. This includes all forms of money like cash, coins, and deposits in banks.
In the given exercise, the nominal money supply is increasing at a rate of 5% per year. This expansion of the money supply, when the velocity of money and real output grow slower, can lead to inflation.
When economists study inflation trends, they watch how changes in the nominal money supply interact with other economic indicators. It's important to monitor because:

• Excessive growth in money supply outpacing real output can devalue the currency, raising the price level.
• It helps in setting monetary policy to maintain economic stability.

Thus, the nominal money supply is a critical component in managing inflation and guiding economic policies.

price level

The price level is a measure of the average prices of goods and services in an economy. It provides an indication of inflation or deflation within a given period. When the price level rises, it reflects inflation, meaning that currency value is decreasing as goods and services become more expensive.
In this exercise, the price level grows by 3% annually, as determined by the rising difference between nominal money supply and real GNP. This corresponds to the inflation rate calculated.

• Maintaining a stable price level is crucial for effective economic planning.
• Central banks aim to keep inflation under control, ensuring economic growth without overly increasing price levels.

Understanding price level dynamics is essential for businesses and consumers alike, as it affects purchasing power and economic stability.