If real GDP grows at 3 percent a year, the quantity of money grows at 5 percent a year, and the velocity of circulation is constant, then the price level must be
A) increasing at 8 percent a year.
B) decreasing at 8 percent a year.
C) increasing at 2 percent a year.
D) decreasing at 2 percent a year.
E) increasing at 15 percent a year.

Question

Quizplus · Accepted Answer

The equation of exchange is MV = PY, where M represents the money supply, V is the velocity of circulation, P represents the price level, and Y represents real GDP. If we assume that the velocity of circulation is constant, we can rearrange this equation to solve for P as P = MV/Y. Given that real GDP grows at 3 percent a year and the quantity of money grows at 5 percent a year, the growth rate of nominal GDP can be calculated as (5% + 3%) = 8%. Since the velocity of circulation is constant, this means that the growth rate of the price level must be 8% - 3% = 5%. Therefore, the answer is C, increasing at 2% a year (since 5% - 3% = 2%).

If Real GDP Grows at 3 Percent a Year, the Quantity