Suppose the velocity of circulation increases by 4 percent and potential GDP grows by 3 percent. The trend inflation rate will equal zero if the quantity of money grows by
A) 0 percent.
B) 1 percent.
C) 4 percent.
D) 3 percent.

Question

Quizplus · Accepted Answer

The trend inflation rate equals zero when the growth rate of the money supply equals the sum of the growth rates of velocity and potential GDP. Here, 4% (velocity) + 3% (potential GDP) = 7%. To have zero inflation, the money supply must also grow by 7%, not by 1%. However, the correct interpretation of the Fisher equation (MV=PY) would imply that to keep the price level (and thus inflation) stable, the growth rate of the money supply (M) should offset the combined effects of the changes in velocity (V) and real output (Y, or potential GDP). The correct answer should reflect the need to balance these factors, but given the choices and the typical understanding of the equation, there might be confusion. The explanation provided was based on a misunderstanding of the question's requirement for zero inflation, which would indeed necessitate adjusting the money supply growth to match the sum of velocity and potential GDP growth rates. However, without an option that matches this sum (7%), there's a mistake in the explanation. The correct approach to achieve zero inflation would involve adjusting the money supply to counteract changes in velocity and potential GDP, but the provided options and explanation don't align correctly with this principle.

Suppose the Velocity of Circulation Increases by 4 Percent and Potential