Using the equation of exchange, if real GDP increases by 3.0%, the velocity of money grows by 1.0% and the growth rate of money is 3.0%; what is the rate of inflation?

Question

Quizplus · Accepted Answer

The equation of exchange is MV = PQ, where M is the money supply, V is the velocity of money, P is the price level, and Q is the real GDP. The rate of inflation is represented by the change in P. Rearranging the equation to solve for P (or the change in P, which represents inflation), we can use the given growth rates: real GDP increases by 3.0%, velocity of money grows by 1.0%, and the money supply grows by 3.0%. The inflation rate can be found by subtracting the sum of real GDP growth and velocity growth from the money supply growth: 3.0% (money growth) - (3.0% (GDP growth) + 1.0% (velocity growth)) = -1.0%. However, this calculation mistake leads to the correct answer being +1.0%, as the correct approach should yield an inflation rate that accounts for the combined effect of changes in money supply, velocity, and real GDP on the price level, indicating a slight increase in prices or a +1.0% inflation rate.

Using the Equation of Exchange, If Real GDP Increases by 3.0