If real GDP grows by 3 percent, the velocity of circulation does not change, and the quantity of money grows by 5 percent, then in the long run the inflation rate is
A) 3 percent.
B) -5 percent.
C) -2 percent.
D) 8 percent.
E) 2 percent.

Question

Quizplus · Accepted Answer

According to the quantity theory of money, MV=PQ, where M = quantity of money, V = velocity of circulation, P = price level, and Q = real GDP. Assuming that V remains constant, a 5% increase in M will lead to a 5% increase in nominal GDP (PQ). If real GDP grows by 3%, then the remaining 2% increase in nominal GDP would be accounted for by inflation. Therefore, the inflation rate would be 2%.

If Real GDP Grows by 3 Percent, the Velocity of Circulation