In the country of Wiknam the velocity of money is constant R

In the country of Wiknam, the velocity of money is constant. Real GDP grows by 3 percent per year, the money stock grows by 8 percent per year, and the nominal interest rate is 9 percent. What is

a. the growth rate of nominal GDP?

b. the inflation rate?

c. the real interest rate?

Solution

As per Classical Quantity Theory of Money:

Money Supply (M) x Velocity (V) = Price level (P) x Real GDP (Y) [Note: Nominal GDP = P x Y]

Change in M + Change in V = Change in P + Change in Y

Since V = Constant, Change in V = 0

Change in M = Change in P + Change in Y

(a) Since Nominal GDP = P x Y,

Change in P + Change in Y = Change in Nominal GDP = Change in M

Change in Nominal GDP = 8%

(b)

8% = Change in P + Change in Y

8% = Change in P + 3% [Since real GDP grows at 3%]

Change in P = Inflation Rate = (8 - 3)% = 5%

(c)

Real interest rate = Nominal interest rate - Inflation rate = (9 - 5)% = 4%