Question

Using the Quantity Theory of Money, calculate the inflation rate if money growth is 14 percent, velocity is 2 percent and real GDP is minus 7 percent. Given your results, is it possible to have higher inflation and lower real economic growth? How might this explain the German hyperinflation/depression of the early 1920s? Today U.S. money growth is 12% and real GDP is down 4%, if velocity is at 2%, what is your outlook for inflation? Implications for the real economy?

Answer 1

a).

According to the Quantity Theory of Money, the following condition must hold.

=> M*V = P*Y, where “M = money supply”, “V = velocity of money”, “P = Price level” and “Y = real GDP”. The above equation can also be written as follows.

=> gm + gv = gP + gY, where “gm = growth of money supply”, “gv = growth of velocity of money”, “gP = inflation” and “gY = GDP growth”.

=> gm + gv = gP + gY, => 14% + 2% = gP + (-7%), => 16% + 7% = gP , => gP = 23%.

b).

According to the Quantity Theory of Money, the inflation can be represented by.

=> gP = gm + gv - gY, => if GDP decreases implied “gY < 0”, => “gP ” increases, => lower economic growth increases the inflation.

c).

In the early 1920, after the 1st world war, the production of Germany decreases significantly, => the GDP growth was negative. On the other hand money supply growth was increased significantly. By, using the Quantity theory of money the inflation is sum of “growth of money supply”, “growth of velocity of money” minus the GDP growth.

=> gP = gm + gv - gY, => if “gv =0”, => gP = gm - gY, => if “money supply” increases and “GDP” decreases, both will increase the inflation.

c).

In US the money growth is 12%, real GDP is down 4% and velocity is at 2%, => the inflation is.

=> gP = gm + gv - gY, => gP = 12% + 2% - (-4%) = 18%, => inflation is “18%”.