You are the head of the central bank and you want to maintain 2 percent long-run inflation, using the quantity theory of money. If the real GDP growth is 4 percent and velocity is constant, you suggest a:
A) 6 percent interest rate.
B) 6 percent money supply growth.
C) 2 percent money supply growth.
D) 0 percent money supply growth.
E) 2 percent interest rate.

Question

Quizplus · Accepted Answer

According to the quantity theory of money, nominal GDP = money supply x velocity = price level x real GDP. Assuming that the central bank wants to maintain 2 percent long-run inflation, the desired increase in the price level is 2 percent. Since real GDP growth is 4 percent and velocity is constant, the required increase in the money supply is also 4 percent (2 percent for inflation and 2 percent for real GDP growth). Therefore, the best choice is option B, which suggests a 6 percent money supply growth.

You Are the Head of the Central Bank and You