Velocity in the country of Aquilonia is always stable. In 2009, the money supply was $100 billion, nominal GDP was $500 billion, and the real interest rate was 3 percent. In 2010, the money supply was $105 billion, and real GDP did not change from its level in 2009. What was the approximate nominal interest rate in 2010?
A)3 percent
B)5 percent
C)8 percent
D)11 percent

Question

Quizplus · Accepted Answer

The velocity of money is stable, so the equation of exchange (MV = PY) holds. With no change in real GDP (Y) and a 5% increase in money supply (M), nominal GDP (PY) also increases by 5%. The Fisher equation states that nominal interest rate = real interest rate + inflation rate. With a 5% increase in nominal GDP and stable real GDP, inflation is 5%. Thus, nominal interest rate = 3% (real interest rate) + 5% (inflation) = 8%.

Velocity in the Country of Aquilonia Is Always Stable