Suppose that an economy is running a fiscal deficit and decides to monetize it. The growth rate of the money supply is 5%, there is no economic growth and the velocity of money is constant. What is the inflation rate? (If your answer is 90%, please write 90)
Question
Suppose that an economy is running a fiscal deficit and decides to monetize it. The growth rate of the money supply is 5%, there is no economic growth and the velocity of money is constant. What is the inflation rate? (If your answer is 90%, please write 90)
Solution
The inflation rate in this scenario would be 5%. This is based on the Quantity Theory of Money, which states that the money supply times the velocity of money equals the price level times real output (MV = PY). If the velocity of money and real output (economic growth) are constant, then any increase in the money supply will lead directly to an increase in the price level, or inflation. Since the money supply is growing at a rate of 5%, the inflation rate will also be 5%.
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