Question

Suppose velocity is constant and output not growing, to get 2% inflation, the Fed should increase the money supply by ______%.

Answer 1

According to quantity theory of money :

M*V = P*Y

where M = money supply, V = velocity, P = price level and Y = Real GDP

Formula :

% change in (A*B) = % change in A + % change in B

=> % change in (M*V) = % change in (P*Y)

=> % change in M + % change in V = % change in P + % change in Y

Here V and Y are fixed => % change in V = 0 and % change in Y = 0 and % change in P is what we all inflation rate and equals 2%

=> % change in M + 0 = 2% + 0 = 2%

Hence, Fed should increase the money supply by 2%