In the long run, an increase of 1 per cent per year in the growth rate of the money supply will increase the rate of inflation in the economy by how much?

Introduction / Context:
Macroeconomics often uses the quantity theory of money and the concept of long run neutrality of money to analyse the relationship between money supply growth and inflation. According to this view, in the long run, changes in the growth rate of the money supply mainly affect the rate of inflation rather than real variables like output. This question tests whether the learner can recall the basic one to one relationship between money growth and inflation in the long run when velocity and real output growth are held constant.

Given Data / Assumptions:
• The money supply growth rate increases by 1 per cent per year. • We consider long run behaviour, not short run fluctuations. • Velocity of money and real output growth are assumed to be constant over time. • We are asked how much inflation will increase in the long run.

Concept / Approach:
The quantity theory of money uses the identity M * V = P * Y, where M is money supply, V is velocity of circulation, P is the price level and Y is real output. Taking growth rates and assuming that velocity growth is zero and real output growth is constant, the theory implies that inflation, which is the growth rate of P, is approximately equal to the growth rate of the money supply minus the growth rate of real output. In the simplest case where real output growth is unchanged, a higher money growth rate translates directly into a higher inflation rate of the same magnitude. Therefore, a one percentage point increase in the money supply growth rate raises inflation by one percentage point in the long run.

Step-by-Step Solution:
Step 1: Write the basic quantity equation M * V = P * Y. Step 2: Express this in terms of growth rates. The growth rate of M plus the growth rate of V equals the growth rate of P plus the growth rate of Y. Step 3: Assume velocity growth is zero, so the growth rate of V is zero, and keep real output growth constant at its existing value. Step 4: Under these assumptions, any permanent increase in the growth rate of M must show up as an equal increase in the growth rate of P, which is the inflation rate. Step 5: Therefore, if the growth rate of the money supply rises by 1 per cent per year, the long run inflation rate will also rise by 1 per cent per year.

Verification / Alternative check:
An intuitive way to confirm this result is to think of an economy where output grows at a steady rate and money is only a tool for making transactions. If the amount of money in circulation grows faster every year while the quantity of goods and services grows at the same pace as before, there is more money chasing the same stream of real output. Over time, this extra money will simply raise prices rather than output, so the rate at which prices rise, that is inflation, increases by the same amount as the extra money growth. Many macroeconomic textbooks summarise this with the simple statement that in the long run inflation is a monetary phenomenon controlled by money supply growth.

Why Other Options Are Wrong:
Zero per cent would imply that an increase in money growth has no effect on inflation even in the long run, which contradicts the quantity theory and most empirical evidence in the long run horizon.
Zero point five per cent would suggest less than one to one transmission from money growth to inflation, which is not what basic long run models imply when velocity and real output growth are fixed.
More than one per cent would indicate that inflation responds more than proportionately to money growth in the long run, which is possible in complex models but is not the standard textbook result that exam questions usually expect for this type of question.

Common Pitfalls:
Learners sometimes confuse short run and long run effects of money supply changes. In the short run, changes in money supply can affect real output and interest rates, so the relationship between money growth and inflation is not simple. Another pitfall is to mix up real and nominal interest rates and assume that changes in money supply affect only interest rates. The key is to remember that in the long run with stable velocity and real output growth, a higher trend growth rate of money primarily produces a higher trend inflation rate of the same magnitude.

Final Answer:
In the long run, an increase of 1 per cent per year in the growth rate of the money supply will raise the inflation rate by one per cent per year.