Question

Suppose that during 2021, the money supply increases by 5%, the inflation rate is 4%, and the growth of real GDP is 2%. What must have happened to the value of velocity during 2021? During 2021, the value of velocity must have increased by _____%

Answer 1

Given the 5% increase in money supply, 4% inflation rate, and 2% real GDP growth, the value of velocity during 2021 must have decreased by 1%.

Step-by-step explanation:

When we consider the value of velocity during 2021, given the money supply increase by 5%, the inflation rate of 4%, and the growth of real GDP at 2%, we can use the Quantity Theory of Money represented by the equation MV = PY. Here, M stands for the money supply, V for velocity, P for the price level (correlating with inflation), and Y for real GDP.

With the given data, the rate of change in nominal GDP (PY) is the sum of the rates of change of the money supply and velocity, since PY = MV. The nominal GDP must have increased by 1% (the sum of the money supply growth and real GDP growth, 5% + 2%, minus the inflation rate, 4%). Therefore, if the money supply increased by 5% and the real GDP by 2%, for the nominal GDP to increase only by 1%, the value of velocity must have decreased by 1%.