Question 4 (20 points) - Topics 2 & 3

a) Suppose the labour force and (physical) capital stock are growing at a rate of 2.5% and 3%

respectively, and the labour share of income is 60%. In addition, the total factor productivity is

increasing at 0.8%.

Note: All the growth rates are annual rates.

"If the velocity of money is rising at 2% and the central bank wants to obtain a target of

inflation at 1.5%, then it should set a monetary growth rate of 5.5%." True/False, explain. (5

points)

Suppose the growth rate of total factor productivity increases by 50% at time T0, what happens

to the price level at time T0? Explain in words. (5 points)

b) (Not related to part a) Suppose you are given the following information:

Real money demand function: L(i, Y) = 0.25Y - 200i

Output: Y = 8000

Money supply: MS = 3200

Note: Both nominal and real interest rates and inflation rate are measured in percentage points (i.e.,

if r = 5, then r = 5%).

"If the equilibrium real interest rate (r) is fixed at 4% and expected inflation is 2%, then the

real money balance is 800." True/False/Uncertain, explain. (4 points)

Find the level of (nominal) money supply if the central bank wants to keep the price level to

5. What happens to the real money balance? Explain. (6 points)