Suppose an economy’s money supply grows by 5% and its real GDP grows at 1%. Assuming the velocity of money remains constant, what is the inflation rate?
Question
Suppose an economy’s money supply grows by 5% and its real GDP grows at 1%. Assuming the velocity of money remains constant, what is the inflation rate?
Solution
The inflation rate can be calculated using the Quantity Theory of Money, which states that the growth rate of the money supply plus the growth rate of velocity equals the inflation rate plus the growth rate of real output (GDP).
In this case, the growth rate of the money supply is 5%, the growth rate of real GDP is 1%, and the velocity of money remains constant (so its growth rate is 0%).
Therefore, the inflation rate can be calculated as follows:
Inflation rate = Growth rate of money supply + Growth rate of velocity - Growth rate of real GDP Inflation rate = 5% + 0% - 1% = 4%
So, the inflation rate in this economy is 4%.
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