According to the growth version of the quantity equation, a 4% increase in the money supply (holding velocity constant) causes a 2% increase in prices only if:
A) nominal GDP increases by 2 percent.
B) real GDP increases by 2 percent.
C) real GDP decreases by 2 percent.
D) nominal GDP decreases by 2 percent.

Question

Quizplus · Accepted Answer

The growth version of the quantity equation is MV=PY, where M is the money supply, V is the velocity of money, P is the price level, and Y is real GDP. Holding velocity constant, a 4% increase in M will lead to a 4% increase in the left-hand side of the equation. In order for the right-hand side to balance, either P or Y or both must increase. If Y remains constant, then a 4% increase in M will lead to a 4% increase in P. However, if Y increases by 2%, then the increase in M will be divided between an increase in P of 2% and an increase in Y of 2%, leading to a 2% increase in P. Therefore, the correct answer is B, as a 4% increase in M with constant V and a 2% increase in Y will cause a 2% increase in P.

According to the Growth Version of the Quantity Equation, a 4