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 percent per year.
a. What is the average inflation rate?
b. How would inflation be different if real income growth were higher? Explain.
c. Suppose, instead of a constant money demand function, the velocity of money is this economy was growing steadily because of financial innovation. How would that affect the inflation rate? Explain.