Consider the money demand function that takes the form (M/P)d = kY, where M is the quantity of money, P is the price level, and Y is real output. If the money supply is growing at a 10 percent rate, real output is growing at a 3 percent rate, and k is constant, what is the rate of inflation in this country?

Question

Quizplus · Accepted Answer

The quantity theory of money states that MV=PY, where M is the money supply, V is the velocity of money, P is the price level, and Y is real output. Rearranging this equation, we get P=MV/Y. 
If we assume that velocity is constant and that the money demand function represents the relationship between money, prices, and real output, then we can substitute (M/P)d for V in the quantity theory equation. This gives us P=M/k. 
Since k is constant in this scenario, a 10% increase in M will lead to a 10% increase in P. Adding the 3% increase in Y, we get an overall inflation rate of 13%. Therefore, the correct answer is B.

Consider the Money Demand Function That Takes the Form (M/P)d