Suppose Velocity for M1 depends on interest rate according to V=...

 

Suppose Velocity for M1 depends on interest rate according to V= 500i , where i is the nominal interest rate.

a. Using the equation for exchange solve for an expression for Real Demand for money balances (M/P).

b. If real interest rate is 2% and expectation of inflation is 2%, and Real GDP is 200 calculate: i. Velocity of M1 ii. Demand for Real money balances in this economy

a)Expression for real demand for money balances=M/P=Y/(500i)

b) i) Velocity of mi= M/P=20

   ii) Demand for real money balances in th economy=10

Step-by-step explanation

According to the theory of exchange;

MV=PY , therefore; M/P=Y/V

where;

M/P= Real Demand for Money Balances or Real Money Demand

Y=Real GDP

P= Price Level

V=Velocity of M1=500i

i=nominal interest rate

M/P=Y/V=Y/(500i)

M/P=Y/(500i) ....................................   Real Demand for Money Balances         

Formula;

i=r+e, where i= nominal interest rate, 

r-real interest rate=2%=0.02, 

e=expected inflation rate= 2%=0.02

Y=200, real GDP

i=0.02+0.02=0.04

Velocity of M1 =500*0.04=20

Y=Real GDP=200

M/P=Y/(500i) =200/(500*0.04)=200/20=10

Demand of real money balances=10