6. The quantity theory of money and prices Aa Aa The quantity equation, also kno

Question

6. The quantity theory of money and prices Aa Aa The quantity equation, also known as the equation of exchange, shows that the product of the money supply (M) and the velocity of money (V) is equal to the product of the price level (P) and real GDP (Q): M x V = P x Q. Consider the fact that any time the left-hand side of the quantity equation, M x V, changes by a certain percentage, the right-hand side, Px Q, must change by the same percentage: Percentage Change in (Mx V)Percentage Change in (Px Q) You can use a general rule about percentage changes to analyze changes in the variables of the quantity equation even further. The percentage change in the product of two variables is approximately equal to the sum of the percentage changes in each of the variables (as long as the percentage changes are fairty small), In the following equation, let "960" stand for "percentage change in". ample, if you know that the money supply grows at a rate of 8% per year, velocity grows at a rate of 1% per year, and real GDP grows at a rate of 5% per year, you can use this rule to determine that the percentage change in the price level is equal to 4% (96&M; + %A-%aq " %&P;). ppose the central bank believes that the velocity of money grows at a predictable rate of 1% per year and that potential real GDP grows at 2% per year. If the central bank observes a rule that stipulates money supply growth of 496 per year, it will expect an inflation rate of year. per year and nominal GDP (P x Q) growth of per Suppose that actual growth in the velocity of money unexpectedly falls to 0.5%. If the central bank continues to adhere to money supply growth of 4% per year and real GDP remained unchanged, the inflation rate will be than anticipated, and nominal GDP growth will be than anticipated.

Explanation / Answer

1) % change in M + % change in V = % change in P + % change in Q

4% + 1% = % change in P + 2%

% change in P = 3%

2) Nominal GDP growth = PxQ = 3 x 2 = 6%

3) 4% + 0.5% = P% + 2%

P% = 2.5 %

Inflation rate will be lower then anticipated.

4) Nominal GDP = 2.5 x 2 = 5%

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