Suppose an economy’s money supply grows by 5% and its real GDP grows at 3%. Assuming the velocity of money remains constant, what is the inflation rate?Note: Do not add the percentage sign; e.g. if you calculate the inflation rate as 1%, enter your answer as 1.
Question
Suppose an economy’s money supply grows by 5% and its real GDP grows at 3%. Assuming the velocity of money remains constant, what is the inflation rate?Note: Do not add the percentage sign; e.g. if you calculate the inflation rate as 1%, enter your answer as 1.
Solution
To calculate the inflation rate, we can use the Quantity Theory of Money, which is expressed in the equation MV = PY.
Here, M is the money supply, V is the velocity of money (which we're told remains constant), P is the price level, and Y is the real GDP.
The growth rate of a product of two variables is approximately the sum of the growth rates. Therefore, the inflation rate (which is the growth rate of the price level P) can be calculated as:
Inflation rate = Growth rate of money supply + Growth rate of velocity - Growth rate of real GDP
Given that the growth rate of the money supply is 5%, the growth rate of real GDP is 3%, and the growth rate of velocity is 0% (since velocity remains constant), we can substitute these values into the equation:
Inflation rate = 5% + 0% - 3% = 2%
So, the inflation rate is 2.
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