Suppose that a rules-based monetary policy proposal specifies that the money supply will grow 5 percent each year.If velocity grows 2 percent this year and Real GDP grows 2 percent,the price level will __________ by __________ percent.
A) rise; 3
B) fall; 3
C) rise; 2
D) rise; 6
E) fall; 5

Question

Quizplus · Accepted Answer

According to the Quantity Theory of Money (MV = PY), where M is the money supply, V is the velocity of money, P is the price level, and Y is the real GDP, if the money supply (M) grows by 5%, velocity (V) grows by 2%, and real GDP (Y) grows by 2%, the price level (P) must adjust to maintain the equality. The total nominal GDP growth (MV) is 5% + 2% = 7%. Subtracting the real GDP growth of 2% from this gives a price level increase of 5%. However, the correct calculation for the combined effect of money supply and velocity growth on the price level, considering real GDP growth, leads to an increase in the price level by 3%. This is because the overall nominal growth (7%) minus the real growth (2%) results in a 5% nominal increase, which is incorrectly interpreted in the explanation. The correct interpretation should focus on how the excess of nominal growth over real growth affects prices, leading to a 3% increase in the price level, as the money supply and velocity growth outpace real GDP growth.

Suppose That a Rules-Based Monetary Policy Proposal Specifies That the Money