Here is some data on the economy of a certain country. Use this data for all three parts of question 1.

M1 Money Supply: $190 Billion

Real GDP: $765 Billion

   Velocity of M1 Money Supply: 4.3

Question 1a: Right now, what is the rate of inflation in that country? How can you tell?

Question 1b: If they want to change the inflation rate to about 2% (which the Fed says is ideal), can they do so by changing the Money Supply? Assuming the velocity stays the same, about how much should the Money Supply be to get to the inflation rate to 2%

Question 1c: Give one example of action the Central Bank of that country could take to reduce the money supply. Explain how your example would work. For this question, assume that the Central Bank of that country has tools for Monetary Policy similar to the tools used by the F.O.M.C. in the USA. You don’t need specific numbers to answer this, just a clear explanation.

Answer:

Here is some data on the economy of a certain country. M1 Money Supply: $190 Billion

Real GDP: $765 Billion

Velocity of M1 Money Supply: 4.3

quantity equation:

money supply × velocity of money = price level × real GDP.

Growth rate of the money supply + growth rate of the velocity of money = inflation rate + growth rate of output. The growth rate of the price level is the inflation rate.

1a) 190*4.3 = 765* Price level

Price level = 1.06 and hence inflation rate would be 0.06*100 = 6%

1b) If they want change in inflation to be at 2 percent. How much the money supply changes so that inflation to be 2%.

M1*4.3 = 1.02* 765

M1 = 181 Therefore at level of 1.02 %inflation

Money Supply is 181

The change in money supply at 6 % inflation compared to previous level of money supply at 2? inflation =190 - 181 = $ 9 billion

1c) For contractionary Monetary policy or to reduce the level of money supply, The Federal Reserve would adopt market operations system in which Federal Reserve will sell government securities and contract the money supply from public and banks got less money to credit and hence money supply reduces in the economy. Even by printing less money would decrease the amount of money circulation. It can even raise the Reserve Requirement which in turn restrict banks in credit processes.