Suppose the money growth rate is 3 percent, velocity is constant, and real GDP is growing at 2 percent. What is the inflation rate?

Question

Quizplus · Accepted Answer

The quantity equation states that MV = PY, where M is the money supply, V is velocity, P is the price level, and Y is real GDP. In this case, V is constant and Y is growing at 2 percent, so the total increase in nominal GDP (PY) is 5 percent (2% real GDP growth + 3% money supply growth). Therefore, if we solve for P we get 5% - 2% = 3% (the increase in the price level), but this is the percentage change. To get the actual percentage increase in prices (i.e. the inflation rate), we need to divide 3% by the initial price level. If we assume an initial price level of 100, then the inflation rate is 3/100 = 0.03, or 3 percent.

Suppose the Money Growth Rate Is 3 Percent, Velocity Is