Suppose velocity is constant, the growth rate of real GDP is 3% per year, and the growth rate of money is 5% per year. Calculate the long-run rate of inflation according to the quantity theory in each of the following cases:

a. What is the rate of inflation in this baseline case?
b. Suppose the growth rate of money rises to 10% per year.
c. Suppose the growth rate of money rises to 100% per year.
d. Back to the baseline case, suppose real GDP growth rises to 5% per year.
e. What if real GDP growth falls to 2% per year?
f. Return to the baseline case and suppose the velocity of money rises at 1% per year. What happens to inflation in this case? Why might velocity change in this fashion?

Explanation:

a)What is the rate of inflation in this baseline case?

( 5% - 3% = 2%

b)Suppose the growth rate of money rises to 10% a year.

10% - 3% = 7%

c)Suppose the growth rate of money rises to 100% a year.

One should be careful here. As we mentioned in the early days, the equalities on growth rates work if the growth rates are small. Here, we have a large growth rate and therefore we should measure Inflation using the initial quality of the quantity theory of money.

Inflation is 94%. (Check the attached document for workings)

d. Back to the baseline case, suppose real GDP growth rises to 5% per year.

5% - 5% = 0%

e)What if real GDP growth falls to 2% per year?

5% - 2% = 3%

f)Return to the baseline case and suppose the velocity of money rises at 1% per year. What happens to inflation in this case? Why might velocity change in this fashion?

NB: the second attached document has the workings.

Inflation increases as compared to original situation. Velocity of money might increase if people are making more transactions on average. The advent of ATMs may increase the velocity of money.

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