Suppose that the growth rate of the money supply is 5 percent per year, the velocity of money is constant, and natural real GDP grows by 3 percent per year. Finally assume that in the long run, actual and natural real GDP grow at the same rate.
(a) What is the rate of inflation in the long run?
(b) Suppose that a beneficial productivity growth shock, such as the one from 1995–2004, causes the growth rate of natural real GDP to increase to 3.5 percent per year. Given no change in the growth rate of the money supply in the long run, what is the new rate of inflation in the long run?
(c) Given the increase in the growth rate of natural real GDP to 3.5 percent per year and supposing that monetary authorities wish to maintain the inflation rate in the long run at the same level as in part a, what action do they need to take?
(d) Suppose that an adverse productivity shock, such as the one from 1965–1980, reduces the growth rate of natural real GDP to 2.5 percent per year. Given that the growth rate of the money supply equals 5 percent per year in the long run, what is the new rate of inflation in the long run? Supposing that monetary authorities wish to maintain the inflation rate in the long run at the same level as in part a, what action do they need to take, given the decline in the growth rate of natural real GDP?
(e) Given the effects of the productivity shocks on the growth rate of natural real GDP, what is an argument in favor of maintaining the growth rate of the money supply at 5 percent and what is an argument in favor of maintaining the inflation rate at a constant level?