Exercise I.
The quantity money equation
Assume an imaginary economy Delta described by the following variables:
1. What is the main contribution of the quantity equation.
It gives a theoretical framework to study inflations’s fluctuations. Indeed, it states that the central bank,
which controls the money supply, has ultimate control over the rate of inflation. If the central bank keeps
the money supply stable, the price level will be stable. If the central bank increases the money supply
rapidly, the price level will rise rapidly.
We assume that for the short-run:
Money supply: 500.
Price per unit of output: $5. To simplify, we assume here that the price per unit of output
is equal to the Consumer Price Index (CPI).
Real output: $1,000
MxV=PxY
V = (P x Y)/M
V = (5 x 1000)/500
=10
The income velocity of money tells us the number of times a dollar bill enters someone’s income in a
given period of time. That is, for $1,000 of GDP per year to take place with $500 of money, each dollar
must enter someone’s income 10 times per year.
2. Use the quantity money equation to calculate the money velocity V .
3. What does the assumption of constant velocity imply?
The quantity equation can be viewed as a definition: it defines velocity V as the ratio of nominal GDP, (P
× Y ), to the quantity of money M . Yet, if we make the additional assumption that the velocity of money
is constant, then the quantity equation becomes a useful theory about the effects of money, called the
quantity theory of money. As with many of the assumptions in economics, the assumption of constant
velocity is only a simplification of reality. Velocity does change if the money demand function changes.
For example, when automatic teller machines were introduced, people could reduce their average money
holdings, which meant a fall in the money demand and an increase in velocity V . Nonetheless,
experience shows that the assumption of constant velocity is a useful one in many situations. Let’s
therefore assume that velocity is constant and see what this assumption implies about the effects of the
money supply on the economy. With this assumption included, the quantity equation can be seen as a
theory of what determines nominal GDP. The quantity equation says: M×V=P×Y where the velocity V is
fixed. Therefore, a change in the quantity of money M must cause a proportionate change in nominal
GDP, i.e. PY. That is, if velocity is fixed, the quantity of money determines the dollar value of the
economy’s output.
We now assume that in the long-run:
• Velocity will increase by 20%.
• Money supply will increase by 10%.
• Real output will increase by 10%.
4. Calculate the inflation rate.
Hint 1.
Ending value - Beginning value
Growth rate (%) = · 100 (1)
Beginning value
Hint 2. The percentage change of a product of two variables is approximately the sum of the
percentage changes in each of the variables. So, considering the quantity money equation, we
obtain:
variation (%) of money supply + variation (%) of velocity =
variation (%) of price + variation (%) of real output 1
Hint 3. Inflation rate is equal to growth rate of CPI. Exercise II. Macroeconomic equilibrium
Method 1:
Variation (%) of M + Variation (%) of V = Variation (%) of P + Variation (%) of Y)
variation (%) of P = variation (%) of M + variation (%) of V − variation (%) of Y
Variation (%) of P = 10% + 20% − 10% = 20%
=20%
Method 2:
M×V=P×Y
P = (MxV)/Y
P = (12x550)/1100
=6
Variation (%) of P = [(6-5)/5]100
=20%
=Inflation
Exercise ii
1. Determine the labor demand function Ld and the equilibrium in the labor market
What exogenous variable has an impact on the equilibrium at the labor market?
dY
(20) MPL =
dL
1 Y = f(L) = AL2
dY
MPL =
dL
1 −1
= AL 2 (22) 2
1 −1
AL 2 =Wreal (23)
2
−1 2
L 2 = Wreal (24) (25)
A
d A2
L=
4W2 real
s d ∗ ∗
L =L ⇒(W ,L ) (26) real
which gives:
12 A2
Wreal = (27) real
25 4W2
and then:
2
4 25×A
Wreal = (28) since A = 40:
4
2
4 25×40
Wreal = (29):
4
2
4 25×40
Wreal = = 10 (30) As for L∗, we write:
4
2 2
∗ 40 10
∗
L =4
(32)
Third step: A is an exogenous variable and represents technological change. If A changes, the
labor market equilibrium may also change.
2. Calculate the real output Y ∗ at the equilibrium.
1
∗
Y =40×4 2 (33)
∗
Y = 80 (34)
3. Study the equilibrium of the money market and calculate P∗. What exogenous variable
has an impact on the equilibrium of the money market?
s d ∗
M =M ⇒P (35)
s
M = M = 40 (36) The equation of the demand for money gives:
M=PY (37) V
M=PY (38) V
∗ Mo ×V
P = (39) Y∗
∗ 40 × 4
P = = 2 (40) 80
o ∗
∆M ⇒∆P (41)
4. Calculate nominal values the the output Y ∗ and wages W ∗ at the equilibrium.
nominal = real × P (42) • P = for prices
= Yreal × P (43) Ynominal
= Wreal × P (44) Wnominal
= 80 × 2 = 160 (45) Ynominal
Wnominal = 10×2=20 (46)
5. Study the equilibrium of the financial market and calculate r∗, S∗ and I∗. What exogenous variable has
an impact on the equilibrium of the financial market?
∗ ∗
S=Ig ⇒(r ,F ) (47)
• Ig = investment (private + public, i.e. I + G).
8000r − 400 = −2000r + 1000 + 200 (48)
∗
1600 = 10000r r = 16%
Public investment is fixed G, making it is an exogenous variable. If G changes, the equilibrium
at the financial market (market of loanable funds) will change.
Putting r∗ value in the saving equation, we obtain:
∗
(51) S = 8000×16%−400 = 880
et :
∗
(52) I =−2000×16%+1000=680
In this exercise, public investment is fixed G. So it is a exogenous variable. If G changes, the equilibrium
at the financial market (market of loanable funds) will change:
∗
∆G ⇒ ∆r (53)
