Question

If a Central Bank is interested in maintaining a stable price level, then in response to an increase in the growth rate of output, the Bank should;

a. increase the growth rate of money by twice the rate as the increase in the growth rate of output

b. increase the growth rate of money by an equal rate

c. increase the growth rate of the velocity of money by an equal rate

d. decrease the growth rate of money by an equal rate

Answer 1

According to QTM (Quantity theory of money)

MV = PY

Where M is money supply

V is velocity

P is price level

Y is real GDP (Output)

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In growth terms:

MV = PY

=> % Growth in M + % Growth in V = % Growth in P + % Growth in Y.

• % Growth in V is zero because V remains constant.
• Central Banks wants price to be stable, so, % Growth in P = 0.

=> % Growth in M + 0 = 0 + % Growth in Y

=> % Growth in M = % Growth in Y

If a Central Bank is interested in maintaining a stable price level, then in response to an increase in the growth rate of output, the Bank should  increase the growth rate of money by an equal rate.

Answer: Option (B).