Answer Happy

2. Answer all parts (a)-(e) of this question.
(a) [5 marks] In the context of the Quantitative Theory of Money
comment on the following sentence: “In order for inflation to be
constant, the growth rate of the money supply should be equal to
the growth rate of real output”.
(b) [3 marks] Write down the “Fisher Equation” and explain the
Fisher effect.
(c) [5 marks] Suppose that the velocity of money is not
constant, and it is related to the nominal interest rate, such that
the velocity is a function of the nominal interest rate: V(i).
Explain how the velocity of money would change when the nominal
interest changes.
(d) [8 marks] Consider the equilibrium in the money market is
given by M/P=L(Y,i), where M denotes the money supply, P the fixed
aggregate price level, i denotes the nominal interest rate and Y
aggregate real income. Suppose that the money market starts at the
equilibrium. Now assume that money supply is increased (everything
else constant). Using a diagram to illustrate your answer, explain
how the interest rate adjusts to maintain the money market
equilibrium in the context of the “theory of liquidity
preference”.
(e) [4 marks] Suppose we are in the long run and the aggregate
price level is flexible. Using the Fisher question in the money
market equilibrium condition M/P=L(Y,i), as in (c), explain how an
increase in expected inflation (everything else constant) will
affect the aggregate price level.