Question

1. What are the major assumptions of Quantity Theory of Money
2. Write down the Equation of Exchange in terms of quantities.
3. Write down the Equation of Exchange in terms of rate of change.
4. If the money supply is increased by 10%, and output did not change, what is the increase in inflation according to the Quantity Theory of Money under the assumption of constant velocity?

Answer 1

a) Accordingly, the velocity of money is held constant. This implies that the number of times a dollar bill is exchanged, does not change over time. In addition, Money supply is exogenous and is determined by the central bank from outside. The theory works in the long run and assumes full employment. Currency money and credit money are constant. Price level is a passive factor.

b) This is given by Price x Real GDP = Nominal money supply x Velocity

c) % change in Price + % change in Real GDP = % change in Nominal money supply + % change in Velocity

Inflation rate + growth rate of real GDP = growth rate of Nominal money supply (% change in Velocity = 0)

d) Inflation rate = growth rate of Nominal money supply - growth rate of real GDP

= 10% - 0%

= 10%.

Thus, inflation rate is 10%.