Suppose velocity increases by 4 percent and potential GDP grows by 3 percent. The trend inflation rate will equal zero if the quantity of money grows by
A) 0 percent.
B) 1 percent.
C) 4 percent.
D) 3 percent.

Question

Quizplus · Accepted Answer

The equation of exchange is MV = PY. If velocity increases by 4% and potential GDP grows by 3%, then the product of these two factors (V*Y) increases by 7%. To keep the price level stable, the quantity of money (M) must increase by the same rate, 7%. Therefore, the quantity of money must grow by 1% (7% - 4% - 3%) to keep the inflation rate at zero.

Suppose Velocity Increases by 4 Percent and Potential GDP Grows