Assuming that velocity is stable, if real GDP grows by 10 percent this year, and if the money supply does not change this year, how much does the price level change by?
A) -10 percent
B) -5 percent
C) 5 percent
D) 10 percent

Question

Quizplus · Accepted Answer

According to the Quantity Theory of Money, MV = PY, where M is the money supply, V is the velocity of money (assumed stable here), P is the price level, and Y is the real GDP. If real GDP (Y) increases by 10% and the money supply (M) does not change, for the equation to balance, the price level (P) must decrease, which corresponds to deflation. A 10% increase in Y with a stable M and V means P must decrease by 10% to keep the equation balanced.

Assuming That Velocity Is Stable, If Real GDP Grows by 10