Answer to Question 3:

If output is growing at 2 percent per year and the demand for money is growing at 1 percent, a 10 percent rate of growth of the nominal money supply will lead to an inflation rate of

1. 10 percent.

2. 9 percent.

3. 7 percent.

4. none of the above.

Choose the correct option.

The correct answer is option 3. From the relative change in the equation of exchange we have

ΔP / P = ΔM / M + Δ V / V − ΔY / Y

M is growing at 10 percent, velocity is declining at 1 percent, and income is growing at two percent. Hence, price level must be growing at

ΔP / P = .10 + (-.01) − .02 = .07

or 7 percent.

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