Question21 You are the head of the RBA and, using the quantity theory of money, you want to maintain 2 percent long-run inflation. If the real GDP growth is 4 percent and velocity is constant, you suggest a 2 percent interest rate. 6 percent money supply growth. 2 percent money supply growth. 6 percent interest rate. 0 percent money supply growth. ResetMaximum marks: 1 Flag question undefined

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BlackTom AI · Accepted Answer

The problem asks us to apply the quantity theory of money, with the goal of 2% long-run inflation. Given MV = PY and the assumption that velocity V is constant, the growth rate of velocity ΔV/V is zero. If real GDP grows by 4% (ΔY/Y = 4%) and we want inflation to rise at 2% (ΔP/P = 2%), then the growth rate of nominal GDP (ΔP/P + ΔY/Y) should be 2% + 4% = 6%. Since ΔM/M ≈ ΔP/P + ΔY/Y + ΔV/V, and ΔV/V = 0, the required growth rate of the money supply M is 6%.

Option-by-option review:

Option: "2 percent interest rate." This is about the policy rate, not the money-supply growth rate, and does not directly tie to the quantity equation as asked. It also ignores the needed money growth to achieve a 2% inflation target given 4% real GDP growth. So this is incorrect.

Option: "6 percent money supply growth." This matches the calculated requirement: with 4% real growth and 2% inflation, and assuming velocity is constant, the money supply must grow by 6% to support nominal GDP growth. This aligns with the quantity theory of money. This is the correct reasoning path.

Option: "2 percent money supply growth." This would understate money growth relative to the needed 6%, failing to support 4% real growth plus 2% inflation in nominal terms. Therefore incorrect.

Option: "6 percent interest rate." Like the first option, this concerns the policy rate rather than money-supply growth, and does not reflect the money-quantity requirement derived from MV = PY. So this is incorrect.

Option: "0 percent money supply growth." This would imply no expansion of the money stock, which cannot sustain positive nominal growth given 4% real growth and 2% inflation target. Therefore incorrect.

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