Question

Suppose that the GDP of the country of Zambia is growing at 1% each year. Also suppose that Zambia has a constant velocity of money and it decides to print money at a much faster rate increasing its money supply by 20%. Using the quantity theory of money, what happens to the price level in Zambia as a result of the printing of money? In other words, will they have inflation? If so, how much? Explain.

Answer 1

The quantity theory of money assumes that the income velocity of money, V, is constant. If V is constant then any increase in nominal gross domestic product, P x GDP, occurs because of an increase in the money supply, M.

Thus by rearranging the equations of the quantity theory of money (MV=P*GDP), we can say that the rate of inflation is equal to the growth rate of the money supply less the growth rate of real output. So here we can see that the growth rate of money supply is higher than the growth rate of real output i.e. the real GDP, So there will be inflation which can be calculated by subtracting growth rate of real output from growth rate of money supply i.e. 20% - 1% = 19%.

As a result of printing the money more faster than the increase in real output the prices of goods and services rise in the economy, this is because there is much greater demand for goods and services than the supply of these goods and services. So in this type of situations where too much money is chasing few goods there is always increase in inflation rate.