In the quantity theory of money, what condition leads to inflation if velocity is stable?

• A. Money demand falls
• B. Velocity rises
• C. Money supply grows faster than real output
• D. Real output grows faster than money supply

Answer: (C)

Inflation shows up when the money circulating in the economy grows faster than the goods and services the economy can produce, assuming the speed at which money circulates (velocity) is stable. In the quantity theory, MV = PY, so with V held constant, increases in M push up nominal spending PY. If real output Y isn’t rising as fast, the extra money bids up the price level P. So the condition that leads to inflation is that the money supply grows faster than real output. If M grows at the same rate as Y, prices stay about the same; if M grows slower than Y, prices would fall.