Quantity Theory of Money: Suppose velocity is constant and real output grows at

Question

Quantity Theory of Money: Suppose velocity is constant and real output grows at 4% per year and money supply grows at 10% per year. Using the Quantity Theory of Money, answer the following: What is the rate of inflation? If the Federal Reserve wants an inflation rate of 2%, what should it do and by how much? Now suppose real output falls by 4%, what will the inflation rate be? Again assume 4% output growth and 10% money supply growth, what will happen to the inflation rate if velocity is not constant but falls?

Explanation / Answer

M x V = P x Q    where M= quantity of money

V= Velocity of money

P = price level

Q= real GDP     

A) 10 * 1= P * 4

P = 10/4 = 2.5

P = 2.5 inflation is 2.5 %

B) Here you have to to be logical what fed can control is the money supply only, It has no control over real output,.

So M* 1 = 2 * 4

Here you have substituted desired inflation rate of 2

m = 8

supply must be 8

C) 10* 1 = P * (4-4)

P = 10/0 = infinity

D) 10*-1= P *4

-10/4 = P

Here i have taken -1 as example as you said velocity is falling, Price level will deflate so we can say deflation will occur.

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