If Real GDP increases at an annual rate of 4 percent and velocity increases at a rate of 2 percent per year,then rules-based monetary policy advocates who wish to maintain a stable price level would set the annual money supply growth rate at
A) -2 percent.
B) 0 percent.
C) 1 percent.
D) 2 percent.
E) -1 percent.

Question

Quizplus · Accepted Answer

The equation of exchange is MV = PQ, where M is the money supply, V is velocity, P is the price level, and Q is real GDP. If Real GDP increases at an annual rate of 4 percent and velocity increases at a rate of 2 percent per year, then we can assume that the growth rate of P will be 2 percent (i.e. 4% - 2%).

To maintain a stable price level, the growth rate of M should equal the growth rate of P. Therefore, the annual money supply growth rate should be set at 2 percent. This choice will ensure that the money supply grows at the same rate as the increase in prices and prevent inflation.

If Real GDP Increases at an Annual Rate of 4