Question

Which of the following is TRUE regarding the quantity theory of money (equation of exchange)?

1. The theory predicts that in the long run the inflation rate equals the money growth rate minus the growth rate of real GDP.
2. The theory predicts that countries with high growth rates of money will have high inflation rates.
3. The theory predicts that if the growth rates of real GDP are higher than the money growth rates while the velocity rates are constant, countries will experience deflation.

Answer 1

Quantity theory of Money

MV = PY

Where M is the money supply

V is the velocity of money

P is the price level

Y is the real GDP.

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In terms of growth:

MV = PY

=> % growth of M + % growth of V = % growth of P + % growth of Y.

Note: V is constant in Quantity theory of money. So, % growth of V = 0

=> % growth of M + 0 = % growth of P + % growth of Y

=> % growth of P = % growth of M - % growth of Y

=> Inflation rate = % growth of M - % growth of Y

TRUE: The theory predicts that in the long run the inflation rate equals the money growth rate minus the growth rate of real GDP.

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We have following equation:

=> Inflation rate = % growth of M - % growth of Y

TRUE: The theory predicts that countries with high growth rates of money will have high inflation rates.

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We have following equation:

=> Inflation rate = % growth of M - % growth of Y

If % growth of Y is higher than % growth of M, then the inflation rate falls below zero. Hence, economy will experience deflation.

TRUE: The theory predicts that if the growth rates of real GDP are higher than the money growth rates while the velocity rates are constant, countries will experience deflation.

Answer: All the three statements are true.