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IAI Actuarial Core Principles · Business Economics · Role of money and interest rates in the economy

In a growing economy, money supply grows by 12% a year, velocity is constant and real output grows by 4% a year. According to the quantity theory, approximately what is the annual rate of inflation?

Inflation is approximately 8% a year. Since money growth plus velocity growth equals inflation plus real output growth, 12% minus 4% real growth leaves 8% as the rate of price increase.

  1. A16%
  2. B3%
  3. C12%
  4. D8%Correct
  5. 4%

Explanation

In growth terms, %ΔM + %ΔV = %ΔP + %ΔY. So 12 + 0 = %ΔP + 4, giving inflation of 8%. Adding the rates (16%) is the sign error; ignoring output growth gives 12%.

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