Suppose that this year’s money supply is $500 billion, nominal GDP is $10 trillion, and real GDP is $5 trillion. a. What is the price level? What is the velocity of money? b. Suppose that velocity is constant, and the economy’s output of goods and services rises by
Answer (2)
The price level is calculated to be 2, indicating prices are twice the base level, while the velocity of money is 20, meaning the money supply is used 20 times in transactions. If real GDP rises and velocity remains constant, nominal GDP will also rise proportionately. Further details would depend on the specific increase in real GDP that is not provided in the question.
;
To solve this question, we need to understand some economic concepts such as the price level and the velocity of money.
a. What is the price level? What is the velocity of money?
Price Level
The price level can be found using the formula for nominal GDP, which is the product of the price level and real GDP:
Nominal GDP = Price Level × Real GDP
Given:
Nominal GDP = $10 trillion
Real GDP = $5 trillion
Rearrange the formula to solve for the Price Level:
Price Level = Real GDP Nominal GDP = 5 trillion 10 trillion = 2
So, the price level is 2.
Velocity of Money
The velocity of money can be calculated using the formula:
Velocity of Money = Money Supply Nominal GDP
Using the given values:
Nominal GDP = $10 trillion
Money Supply = $500 billion
Convert $10 trillion to $10,000 billion to match the units:
Velocity of Money = 500 billion 10 , 000 billion = 20
Thus, the velocity of money is 20.
b. Suppose that velocity is constant, and the economy’s output of goods and services rises...
To address the second part of the question related to changes in output, note that with the velocity of money assumed constant, any increase in real GDP (output of goods and services) implies a proportional increase in nominal GDP if the money supply remains the same. This follows from the equation:
Nominal GDP = Velocity of Money × Money Supply
Since the velocity stays constant, changes in one variable will affect others accordingly to maintain the equation balance. Understanding this relationship is fundamental when analyzing how output growth can affect nominal variables like GDP.
