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Question 1: Money and Infation (20 Marks)
Suppose that a typical country’s money demand function Md is given by:
Md = PY 0:75
where P stands for the price level and Y for output.
(a) What is the income elasticity of money demand?
(b) If in the current year the price level is P = 1, how much do the money supply Ms and output Y need
to be for the velocity V to be equal to 1:5?
(c) How much is the predicted ination rate if the money supply has been growing at 2:0% per year,
while real output has been growing at 4:0% per year?
(d) Are the following money demand functions compatible with the Quantity Theory of Money? Why?
i) Md = P
Y 3 + Y 2 + Y
ii) Md =
iii) Md = 1
4Y ???? 2i (i stands for the nominal interest rate):
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