Suppose a country has a money demand function (M/P)d = kY, where k is a constant parameter. The money supply grows by 12% per year, and real income grows by 4% per year.
(a) What is the average inflation rate?
(b) How would inflation be different if real income growth were higher, say 6%? Explain.
(c) Suppose, instead of a constant money demand function, the velocity of money in this economy was growing steadily, say by 2% per annum because of financial innovation. How would that affect the inflation rate? Explain.