The velocity of money is 5, real GDP is 100 and the money supply is 100. According to the quantity theory of money, a 20 percent increase in the money supply causes a
A) 10 percent decrease in average prices.
B) 10 percent increase in average prices.
C) 5 percent decrease in real GDP.
D) 20 percent decrease in velocity.
E) 20 percent increase in average prices.

Question

Quizplus · Accepted Answer

According to the quantity theory of money, MV=PQ where M is money supply, V is velocity of money, P is price level, and Q is real GDP. Therefore, (100*5)/100 = P*100, which gives us a price level of 5. If the money supply increases by 20 percent, this means there will now be 120 in the money supply. Using the same equation, we can find the new price level: (120*5)/100 = P*100, which gives us a new price level of 6. Therefore, there is a 20 percent increase in average prices (choice E).

The Velocity of Money Is 5, Real GDP Is 100