# Assuming output Y is determined exogenously, and demand for realmoney balances is given by (M/P) d =

Assuming output Y is determined exogenously, and demand for realmoney balances is given by (M/P) d = kY , answer the following: (a) Suppose k changes from period to period. Using the quantityequation MV = P Y , show how inflation is related to money growth,output growth, and growth in k. (b) Holding the money supply M and output Y constant, does afall in k lead to inflation, deflation, or no change in the pricelevel? Explain in words why this is. (c) Since inflation erodes the purchasing power of money, higherinflation could be expected to cause a fall in demand for realbalances. Suppose this is the case. In particular, suppose %∆k =−aπ, where 0 ≤ a < 1, and π is inflation. Under this assumption,show how inflation is related to money growth and output growth(i.e., solve for π in terms of %∆M and %∆Y ). (d) Suppose the central bank always sets %∆M = %∆Y + x, where xis some constant, with x > 0. Based on your answer from (c), ifa increases (but remains less than 1), what will happen toinflation (i.e., will is stay the same, increase, or decrease)?Explain your answer intuitively . . .

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