In an economy in which real output grows at an average rate of 3 percent per year, a 7 percent average rate of growth in the money supply would result in
A) an inflation rate of 4 percent, if velocity were constant.
B) an inflation rate of −4 percent, if velocity were constant.
C) a $4 increase in the price level per year.
D) a $4 decrease in the price level per year.

Question

Quizplus · Accepted Answer

According to the quantity theory of money, MV=PQ, where M is the money supply, V is velocity (the number of times the average dollar is spent per year), P is the price level, and Q is real output. Assuming velocity is constant, a 7 percent growth in M would lead to a 7 percent growth in PQ, which corresponds to a 7 percent growth in nominal output. With real output growing at 3 percent per year, the remaining 4 percent of nominal output growth must come from inflation, meaning the inflation rate would be 4 percent.

In an Economy in Which Real Output Grows at an Average