Suppose velocity of money is constant, the growth rate of real GDP is 3% per yea

Question

Suppose velocity of money is constant, the growth rate of real GDP is 3% per year, and the growth rate of money is 5% per year. Consider this a aseline." In each case show (don't just state) what's happening. I.e., show your work. (a) What is the rate of inflation in this baseline case? (b) What happens if the growth rate of money rises to 10% per year? (c) What happens if the growth rate of money rises to 100% per year? (d) Return to the baseline case; what would happen if real GDP growth were to rise to 5% per year? (e) What would happen if real GDP growth fell to 2% per year? (f) Again go back to the baseline case; what happens to inflation if money velocity rises at 1% per year. What might cause money velocity to change like this?

Explanation / Answer

According to the quantity theory of money, if the velocity of money is constant then:

Growth rate in Money Supply = Inflation rate + Growth rate of real GDP

(a) Using the above equation we get:

Inflation rate = Growth rate in Money Supply - Growth rate of real GDP = 5% - 3% = 2%

(b) If Growth rate in Money Supply = 10%, then

Inflation rate = Growth rate in Money Supply - Growth rate of real GDP = 10% - 3% = 7%

(c) If Growth rate in Money Supply = 100%, then

Inflation rate = Growth rate in Money Supply - Growth rate of real GDP = 100% - 3% = 97%

(d) If Growth rate of real GDP = 5%, then

Inflation rate = Growth rate in Money Supply - Growth rate of real GDP = 5% - 5% = 0%

(e) If Growth rate of real GDP = 2%, then

Inflation rate = Growth rate in Money Supply - Growth rate of real GDP = 5% - 2% = 3%

(f) If velocity of money is not constant, the

Growth rate in Money Supply + Growth rate of Money Velocity = Inflation rate + Growth rate of real GDP

Using the equation above, we get

Inflation rate = Growth rate in Money Supply + Growth rate of Money Velocity - Growth rate of real GDP

= 5% + 1% - 3% = 3%

A host of reasons can lead to an increase in velocity

1. expansion of credit facilities

2. increase in volume of trade

3. money supply relative to requirements falls

4. money demand falls due to a significant increase in prices

For more detailed discussion, see

http://www.preservearticles.com/201012281811/factors-influencing-velocity-of-money.html

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