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IAI Actuarial Core Principles · Business Economics · Business activity, unemployment and inflation

Money supply grows by 10% a year, real output grows by 3% a year, and velocity of circulation is constant. Using the quantity theory of money (MV = PY) in growth-rate form, approximately what is the inflation rate?

Inflation is approximately 7%. With constant velocity, money growth equals inflation plus real output growth, so inflation is 10% minus 3%. Output growth absorbs part of the extra money, leaving only the remainder to raise prices.

  1. A13%
  2. B3%
  3. C10%
  4. D7%Correct
  5. 0.3%

Explanation

With V constant, %change M = %change P + %change Y, so inflation is approximately 10% - 3% = 7%. Adding the rates (13%) uses the wrong sign for output growth. Ignoring output gives 10%, a missed adjustment.

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