Discussion
If the nominal money supply grows by 4% per year, velocity is constant and the real GDP grows by 1% per year, inflation would be ................ .
Answer: C
Inflation would be 3%.
The quantity equation MV = PY in growth rates gives:
\[ \begin{aligned} \%\Delta M + \%\Delta V &= \%\Delta P + \%\Delta Y \\ 4 + 0 &= \pi + 1 \\ \pi &= 3\% \end{aligned} \]
Money grows by 4% and velocity is constant, so nominal GDP grows by 4%; with real output growing 1%, prices must rise by 3%. Taking 4% ignores real growth, and 1% confuses the growth of output with inflation.
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