Question

Question 6: Inflation and the quantity theory Suppose velocity is constant, the growth rate of real GDP is 3% per year, and the growth rate of money is 5% per year. Calculate the long-run rate of inflation according to the quantity theory in each of the following cases: (a) What is the rate of inflation in this baseline case? (b) Suppose the growth rate of money rises to 10% per year. (C) Suppose the growth rate of money rises to 100% per year. (d) Back to the baseline case, suppose real GDP growth rises to 5% per year. (e) What is real GDP growth falls to 2% per year? (f) Return to the baseline case and suppose the velocity of money rises at 1% per year. What happens to inflation? Why might velocity change in this fashion?

Answer 1

MV =PY,

Money supply growth = GDP growth + inflation ( as velocity is constant)

Inflation = (Growth rate of money) – (Growth rate of real GDP)

1)

a)
5% - 3% = 2%.

Inflation is 2%

b)10% - 3% = 7%

c) 100% - 3% = 97%

d) 5% - 5% = 0%

e)5% - 2% = 3%

f) Inflation = money supply growth + velocity change - GDP Growth
Inflation = 5% + 1% - 3% = 3%
Inflation will be 3%