Question

Suppose the growth rate of velocity becomes very unstable and fluctuates wildly. Explain why this development would make it more difficult for the government to keep the inflation rate steady.

Answer 1

Under the quantity theory of money we have MV=PY, where M is the money supply, V is the velocity of circulation, P is the price level and Y is the output level. If the velocity of money fluctuates rapidly then this will mean that the money supply will change hands more often. Now given that this happens the right hand side of the equation also fluctuates and so the price level also fluctuates rapidly in keeping with nominal output. Thus the rapidly fluctuating velocity of circulation will also have an effect on the inflation rate and hence the price level. This makes the inflation level difficult to control as the money supply circulates faster than ususal.