Suppose the Fed sets an inflation target of 2% a year. If economic growth averages 3% per year and velocity grows by 1% per year, by how much should it increase the money supply each year?
A)2%
B)4%
C)5%
D)6%

Question

Quizplus · Accepted Answer

The equation of exchange (MV = PQ) can be rearranged to solve for the growth rate of the money supply (M) as M = (PQ)/V. Given the inflation target of 2% per year, P (the price level) is expected to increase by 2% per year. Therefore, we can assume that the growth rate of nominal GDP (PQ) is 5% per year (3% real economic growth + 2% inflation). If velocity (V) grows by 1% per year, then the Fed needs to increase the money supply by 4% per year [(5% growth rate of PQ - 1% growth rate of V) = 4% growth rate of M]. Therefore, the correct choice is B.

Suppose the Fed Sets an Inflation Target of 2% a Year