An increase of 1% per annum in the rate of growth of the money supply will increase inflation in the long run by ________.
- AZero percent
- BOne percent
- C0.5 percent
- DMore than one percent
Solution & Step-by-step Explanation
According to the Quantity Theory of Money (formulated by classical economists and revived by monetarists like Milton Friedman), in the long run, real output depends on structural factors of production and technology, not on money supply (monetary neutrality).
The equation of exchange is given by:
M×V=P×Y
Taking the percentage growth rate form:
%ΔM+%ΔV=%ΔP+%ΔY
Where:
M is the money supply
V is the velocity of money (assumed constant in the long run, so %ΔV=0)
P is the price level (inflation rate is %ΔP)
Y is the real GDP (growth rate %ΔY is fixed by real factors in the long run)
Therefore, any change in the growth rate of the money supply (%ΔM) translates into a direct, one-for-one change in the inflation rate (%ΔP) in the long run. An increase of 1% in the growth rate of the money supply increases inflation by exactly 1% per annum.
The equation of exchange is given by:
M×V=P×Y
Taking the percentage growth rate form:
%ΔM+%ΔV=%ΔP+%ΔY
Where:
M is the money supply
V is the velocity of money (assumed constant in the long run, so %ΔV=0)
P is the price level (inflation rate is %ΔP)
Y is the real GDP (growth rate %ΔY is fixed by real factors in the long run)
Therefore, any change in the growth rate of the money supply (%ΔM) translates into a direct, one-for-one change in the inflation rate (%ΔP) in the long run. An increase of 1% in the growth rate of the money supply increases inflation by exactly 1% per annum.