2 marksMacroeconomicsDemand for money and monetary theoriesMonetarism, neutrality and monetary rulesModerateabout 2 min

GATE 2021 Question 37: Demand for money and monetary theories

Let the rate of inflation in an economy be 4.2%, the growth rate of velocity of money be 2% and, the growth rate of real GDP be 6%. According to Milton Friedman's 'k' percent rule, the rate of growth of money supply for maintaining stable prices will be ______ (round off to one decimal place).

Answer and worked solution

Answer: 4.0

The quantity theory of money, in growth-rate (percentage change) form, is:

$g_M + g_V = g_P + g_Y$

where $g_M$ is money supply growth, $g_V$ is velocity growth, $g_P$ is inflation, and $g_Y$ is real GDP growth.

Friedman's k-percent rule asks: what constant rate of money supply growth would be needed to achieve price stability — i.e., a target inflation rate of $g_P=0$ — given the economy's structural growth rates of velocity and real output?

Rearranging for $g_M$ with the target $g_P=0$ :

$g_M = g_P^{target} + g_Y - g_V = 0 + 6\% - 2\% = 4\%$

Note that the currently observed inflation rate of 4.2% is contextual information describing the economy's present state — it is not used in computing the target money-growth rate needed for future price stability, which depends only on the structural growth rates of $Y$ and $V$ .

Therefore the required money supply growth rate is 4.0%.

The trap: 8.2

Students sometimes mistakenly incorporate the given 4.2% current inflation rate into the formula (e.g., computing $g_M = 4.2+6-2=8.2$ , which would describe the money growth CONSISTENT WITH the current inflation, not the money growth needed to ACHIEVE price stability) — the question specifically asks for the rate needed to maintain STABLE prices (zero inflation), which requires setting $g_P=0$ in the identity, not plugging in the observed current inflation figure.

Demand for money and monetary theories has come up 82 times in 7 exams since 2005.

What this question tests

This question is on Monetarism, neutrality and monetary rules, part of Demand for money and monetary theories in Macroeconomics.

The long-run neutrality of money and the case for rules over discretion.

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