CFA Level IEconomicsMedium
A central bank increases the money supply by 8% over the year. Velocity of money rises by 2%, and real GDP grows by 3%. According to the quantity theory of money, what is the approximate inflation rate implied for the year?
- A7%
- B5%
- C13%
- D3%
Show answer & explanationAnswer & explanation
Correct answer: A. 7%
The quantity theory identity MV = PY implies %ΔM + %ΔV = %ΔP + %ΔY. Substituting: 8% + 2% = %ΔP + 3%, so %ΔP = 10% - 3% = 7%. This reflects both money growth and velocity growth flowing into prices, net of real output growth.
Why the other options are wrong
- B. Incorrect—this would result if velocity were held constant and only money growth (8%) minus GDP growth (3%) were used.
- C. Incorrect—this sums all growth rates without subtracting real GDP growth.
- D. Incorrect—this only reflects real GDP growth, ignoring money and velocity growth.
Quantity Theory of Money
The identity MV = PY relates money supply (M), velocity (V), price level (P), and real output (Y); in growth-rate form, %ΔM + %ΔV ≈ %ΔP + %ΔY.
- MV = PY is the equation of exchange
- Growth-rate form: %ΔM+%ΔV=%ΔP+%ΔY
- Assumes velocity is often treated as stable, but not always constant
Memory trick: 'MV=PY': More money or faster spending (V) pushes prices up unless output keeps pace.