Question

1. Using the quantity equation, what happens to the price level if the money supply increases by 10%, velocity is constant, and real GDP does not change?

2. Using the quantity equation, what happens to the price level if the money supply increases by 10%, velocity is constant, and real GDP increases by 5%?

Answer 1

The quantity theory of money is as follows -

M * V = P * Y

M = Money Supply

V = Velocity

P = Price Levels

Y = GDP

The equation can also be represented as "sum of growth rate" for the variables.

M + V = P + Y

Answer 1.

M = 10% ; V = 0% ; Y = 0%

Or,

10 + 0 = P + 0

Or,

P = 10%

Therefore, when money supply increases by 10% and real GDP does not change, price level increases by 10%

Answer 2.

M = 10% ; V = 0% ; Y = 5% ;

Or,

10 + 0 = 5 + P

Or,

P = 5%

Therefore, when money supply increases by 10% and real GDP by 5%, the price level increases by 5%.