Question

Consider an economy has had growth in real GDP of 3.1% and growth in the money supply of 4.9%.

a) If velocity has been constant for this economy, what will be the rate of inflation?

b) If instead the velocity had increased by 5.6%, what will be the rate of inflation?

c) The quantity theory of money theorizes that the rate of inflation is determined by the growth of the money supply. What is the key assumption for the quantity theory of money? How well does this theory work to explain observed data in the short run and the long run?

Answer 1

1. Quantity theory of money- MV = PY

Log M + Log V = Log P + log Y, where Y is real GDP

Growth in money supply+ growth in velocity = growth in prices + growth in real GDP

a) 4.9+0= inflation + 3.1

Inflation rate = 1.8%

b) 4.9+5.6 = inflation + 3.1

Inflation = 7.4%

c) Quantity theory of money was given by Classical school of economists. As per them, velocity and money and real GDP is constant over time, thus any change in money supply is reflected in prices.

Classical economists examined long term behaviour and said that prices are flexible, thus prices get adjusted to change in money supply.

But Keynesian and Monetarist school of thought critises this view of Classical economists, because this theory will be failed in short run, when prices are sticky.