According to the general monetary model with the purchasing power parity, if there is a permanent increase of 2 percentage points in the domestic money supply growth rate, other things equal, then the long-run growth rate of the real money balance (M/P) of the domestic country:

Question

According to the general monetary model with the purchasing power parity, if there is a permanent increase of 2 percentage points in the domestic money supply growth rate, other things equal, then the long-run growth rate of the real money balance (M/P) of the domestic country:

BlackTom AI · Accepted Answer

Question restatement: The problem asks, within the general monetary model with purchasing power parity (PPP), what happens to the long-run growth rate of the domestic country's real money balance (M/P) if there is a permanent increase of 2 percentage points in the domestic money supply growth rate, all else equal.

Option a: does not change. This choice asserts that the long-run real money balance is unaffected by a permanent rise in the money growth rate. In PPP frameworks with a stable long-run growth path for real variables and a stable price-level process, a permanent increase in money growth typically shifts the inflation rate but does not alter the steady-state growth rate of real money balances, because the real balance M/P adjusts to keep real demand in line with real income and the price level grows proportionally with money growth. If velocity is stable and real income growth is unchanged, the long-run ratio M/P tends to be governed by real determinants rather than nominal surprises, so this option is plausible.

Option b: falls by 4 percentage points. This would imply a sizable negative impact on the long-run growth rate of M/P, specifically a 4 percentage point drop. In a PPP setting with a permanent 2-percentage-point increase in money growth, there is no conventional mechanism that creates a 4-point fall in the long-run real money balance unless there is an extra, asymmetric adjustment in other variables (like a large, persistent drop in real money demand or a permanent, large drop in real income growth). The problem statement provides no basis for such an additional shift, making this option unlikely.

Option c: rises by 2 percentage points. This would mean the real money balance grows faster by exactly the same amount as the permanent increase in money growth. However, a permanent rise in money growth tends to raise the inflation rate, and unless real money demand or real income also shifts in a compensating way, the long-run real money balance does not automatically rise by the same amount. PPP and standard monetarist intuition usually imply that higher money growth translates into higher prices rather than a higher real balance in the long run, all else equal, so this option is not consistent with the typical long-run neutrality of real balances to permanent money growth.

Option d: falls by 2 percentage points. This option suggests a direct, equal-opposite response of M/P to the 2-point increase in money growth. In standard interpretations, a permanent increase in money growth raises inflation, and since real money balances reflect the real quantity of money after adjusting for price changes, the strict one-for-one fall in M/P is not a standard outcome unless there is an offsetting drop in real income growth or a change in money demand. With only a permanent increase in money growth and otherwise unchanged real fundamentals and velocity, a 2-point fall is not the typical or implied long-run result.

Synthesis: Evaluating each option against the canonical implications of a permanent rise in money growth under PPP, the most consistent takeaway is that the long-run real money balance M/P remains unchanged in its growth rate, while prices adjust one-for-one with the higher money growth. The other options require additional shifts or mechanisms not specified in the problem.

Note: The explanations above trace how each choice aligns (or misaligns) with the standard logic of PPP and the long-run neutrality of real money balances to permanent money-growth changes, emphasizing why the plausible, theory-consistent outcome is that the long-run growth rate of M/P does not change with a permanent 2 percentage point increase in money growth.

ECF2721 - S1 2025 Week 4 Sample Questions

According to the general monetary model with the purchasing power parity, if there is a permanent increase of 2 percentage points in the domestic money supply growth rate, other things equal, then the long-run growth rate of the real money balance (M/P) of the domestic country:

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