Monetary Theory and Policy. Use the equation of exchange to answer the following questions and assume that the velocity of money is fixed at V = 7.5 throughout this problem.

The equation of exchange is × = × . The price level given in this equation is the GDP price index discussed on page 110 of the textbook (many people call it the GDP price deflator). In order to use the GDP price index in this equation, we need to divide it by 100 (its base year value). So we use a price level of 1.25 instead of 125, i.e. 1.25 = A price level of 112 would be 1.12 in this equation, etc… If this causes any confusion, please let me know.

a. Suppose that the economy is in long-run equilibrium. If the money supply is $2 trillion and the price level is 1.25, show that potential output is $12 trillion.

b. Again, suppose the Fed has increased the money supply by 10% to $2.2 trillion, what happens to the price level after the economy has adjusted back to full employment? Does it go up or down? What is the new price level? Show your work.