Question

6. What is the formula for the equilibrium price level according to the quantity theory? Write the implied equation for inflation and use the equation to explain why inflation could rise or fall in an economy (5 points)

Answer 1

According to quantity theory of money,

MV= PY

P= MV/Y

This is the equilibrium price condition.

MV= PY

In growth terms, assuming constant velocity

Money supply growth rate= inflation rate+ real gdp growth rate

Inflation rate= money supply growth rate - real gdp growth rate

When money supply increases or real gdp falls, inflation increases.

When money supply decreases of real gdp rises, inflation decreases.