Answer to Question 1
The economy would go from a short-run equilibrium below potential GDP to a short-run equilibrium above potential GDP. The increase in government purchases, which equals the shortfall in real GDP from potential real GDP, is too large. The increase in government purchases needs to be less than the shortfall in real GDP because of the multiplier effect.
Answer to Question 2
If one assumes that the velocity of money is constant, there are clear implications on how to use monetary policy for price stability. If we transform the quantity equation, MV = PY, into an equation about growth rate for these variables, then the quantity equation becomes:
growth rate of money + growth rate of velocity = growth rate in prices (inflation rate) + growth rate of real output.
Rearranging, we get:
inflation rate = growth rate of money + growth rate of velocity - growth rate of real output. If velocity does not change, then the growth rate of velocity is zero. Then, inflation is determined by:
growth rate of money - growth rate of output. As long as money does not grow faster than real output, inflation will not occur. If the supply of money grows faster than the growth of real output, the result will be inflation.
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