Question

Suppose that the annual growth rate of real GDP is 3 percent per year and the growth rate of the money supply is 10 percent per year. If the velocity of circulation remains constant (a zero growth rate), then the inflation rate is _______ percent per year.

Answer 1

If the velocity of money is constant and with a real GDP growth rate of 3% and a money supply growth rate of 10%, the inflation rate would be 7% per year.

Step-by-step explanation:

Velocity of money is a measurement of the rate at which money is exchanged in an economy. The velocity of money equation divides GDP by money supply. The velocity of money formula shows the rate at which one unit of money supply currency is being transacted for goods and services in an economy.

Using the basic quantity equation of money, which states that if the velocity of circulation remains constant, then a certain percentage rise in the money supply will lead to the same percentage rise in nominal GDP. Given that real GDP is growing at 3% and the money supply at 10%, and assuming velocity is constant, the difference between these two percentages will be reflected in the inflation rate. Thus, the inflation rate is calculated as follows: Inflation rate = Growth rate of money supply - Growth rate of real GDP, Inflation rate = 10% - 3%, Inflation rate = 7%. Therefore, the inflation rate is 7 percent per year.