Suppose potential GDP is growing at 2% per year and velocity is stable. According to the quantity theory of money, a central bank that wants to target 2% inflation should expand the money supply at what rate?
Question
Suppose potential GDP is growing at 2% per year and velocity is stable. According to the quantity theory of money, a central bank that wants to target 2% inflation should expand the money supply at what rate?
Solution
The Quantity Theory of Money states that the general price level of goods and services is directly proportional to the amount of money in circulation, or money supply. The formula for this theory is MV = PT, where:
- M is the money supply
- V is the velocity of money (the rate at which money is exchanged from one transaction to another)
- P is the price level
- T is the volume of transactions of goods and services
Given that potential GDP growth is 2% per year and velocity is stable, the central bank would need to increase the money supply at a rate that would result in a 2% increase in the price level (inflation) to keep the equation balanced.
If we assume that the volume of transactions (T) grows at the same rate as potential GDP, then the growth rate of the money supply (M) should be the sum of the growth rate of potential GDP and the inflation rate.
So, if potential GDP is growing at 2% per year and the central bank wants to target 2% inflation, it should expand the money supply at a rate of 4% per year (2% potential GDP growth + 2% inflation target = 4% money supply growth).
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