Question

Suppose an economy has a money growth rate of 5%, a velocity growth rate of 2%, and a Solow growth rate of 4%. What is the inflation rate in this economy in a long run equilibrium?

3%

5%

10%

2%

Answer 1

Option A.

• In order to calculate the inflation rate in this economy in a long run equilibrium, we can use the equation of quantity theory of money.
• This equation shows the relationship between the price's and the money supply that prevail in the Economy at the current inflation rate.
• The equation is given by : QTM = M + V = P + Y

Where, M = Money growth(5%) , V = velocity of money(2%), P = interest rate/ price level(?), Y = real GDP( 4%)

By substituting these in the equation we get,

QTM = M+V = P+Y

5 + 2 = P + 4

P + 4 = 7

P = 7 - 4 = 3%

Therefore, the inflation rate in this economy is 3%.