Macroeconomics Asset Market Question (Chegg is Garbage Pt. 1)
Consider an economy with a constant growth rate of nominal money supply and a constant real interest rate r = 0.06. Which of the following statements about the inflation rate of the economy would be valid?
a. The long-term inflation rate would be equal to the money growth rate regardless of the output growth.
b. The ultimate determinant of the inflation rate is how people form their expectation of future inflation.
c. Without knowing the nominal interest rate, π + 0.09, one can not tell the real demand for money and hence the inflation rate.
d. The faster the economy’s real output grows, the lower the inflation rate.
The answer according to Google, Chegg, Homework.Study.com will give you the wrong answer. I ignored them because I trust myself more than even textbooks. I’ll break down the problem and give you the solution at the end if you still can’t figure it out.
The inflation rate = % change in money supply - income elasticity of money demand * % change in real output - interest elasticity of money demand * % change in interest rates.
We know from theory that when real income/output increases, the demand for money also increases. Therefore, the income elasticity of money demand is positive. We also know that when interest rates go up for non-monetary assets such as bonds, there is a lower demand for money, hence there is a negative interest elasticity of money demand.
In the question, we are told that the growth rate of the money supply is constant, and interest rates are constant. Therefore, only the change in real output can affect the inflation rate. You should be able to figure out the answer now.
Answer
The faster the economy’s real output grows, the less effect money supply growth has on the change in price levels; lower inflation rate.
Note that since the money supply is growing every year, the economy has to also grow every year to keep the inflation rate lower than without any output growth.
Just goes to show you that sure you can Google a question, but if you are intelligent or have mastered a field, you should have the confidence to disregard information you read online even from “trusted authorities.” Obviously, this doesn’t mean you don’t bow down to the scientific method where empirical evidence is king.