Suppose a country has a money demand function (M/P)d = kY, where k is a constant parameter. The money supply grows by 12 percent per year, and real income grows by 4 percent per year.
a. What is the average inflation rate?
b. How would inflation be different if real income growth were higher? Explain.
c. Suppose that instead of a constant money demand function, the velocity of money in this economy was growing steadily because of financial innovation. How would this situation affect the inflation rate? Explain.