Suppose the full-employment level of real GDP is increasing at a rate of 3% per period and the money supply is growing at a 3% rate. Using the equation of exchange, what is the value of the long-run inflation rate, assuming constant velocity?
A) 6%
B) 3%
C) 1%
D) 0%

Question

Quizplus · Accepted Answer

The equation of exchange is expressed as MV=PY, where M is the money supply, V is velocity, P is price level, and Y is real GDP. Assuming constant velocity, we can solve for P as follows:

P= MV/Y

If the full-employment level of real GDP is increasing at a rate of 3% per period and the money supply is growing at a 3% rate, then the nominal GDP will grow at a rate of 6% (3% + 3%). However, since we assume that velocity is constant, the inflation rate will be equal to the growth rate of the money supply, which is 3%. Therefore, the answer is D, 0%.

Suppose the Full-Employment Level of Real GDP Is Increasing at a Rate