Quantity Theory of Money

Question – 3 In the economy of Attica, prices are perfectly flexible and output is always at its full employment level Y. Assume that the Quantity Theory of Money (QTM) is valid. The velocity of circulation of money is constant, and the stock of money, M, grows at a constant rate, m. Aggregate demand, the is curve, is given by yo = A – b R – 12), where R is the nominal rate of interest and it is the expected rate of inflation. A and b are constant parameters. (a) What is the inflation rate, n, in Attica? (b) If the inhabitants of Attica have perfect foresight, what is the effect of increasing the growth rate of money supply on real and nominal interest rates? (c) Is the stock of real money balances affected by the rate of growth of the money supply? (d) Imagine now that due to an increase in financial sophistication in Attica the demand for money becomes sensitive to the interest rates so that in place of the quantity theory equation, we have (M/P)’ = H – KR, where d, H and k are constant parameters. How are your answers to parts (a) to (c) above affected by this development? Is money neutral, and/or supernatural in Attica?

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