Question

If the money supply is growing at a rate of 3 percent per​ year, real GDP​ (real output) is growing at a rate of 0 percent per​ year, and velocity is growing at 3 percent per year instead of remaining​ constant, what will the inflation rate​ be?

Answer 1

From the quantity theory of money equation we know that:

           MV = PY

or,             % growth M + % growth V = % growth P + % growth Y

where

M is the money supply

V is the velocity of money

P is the overall price level

Y is real GDP

Suppose that the money supply is growing at a rate of 3 percent per​ year, real GDP​ (real output) is growing at a rate of 0 percent per​ year, and velocity is growing at 3 percent per year instead of remaining constant, then inflation will be

           3 % + 3 % = % growth P + 0 %

          Therefore, % growth P = 6%

Had velocity being 0, P would have been 3%. But now that velocity grows at 3 percent; this will cause prices to grow by 6 percent. Inflation increases because the same quantity of money is being used more often to chase the same amount of goods.