28. The Monetary Policy Rule and the Velocity of MoneyThe quantity equation shows that the product of the money supply (M) and the velocity of money (V) is equal to the product of the price level (P) and real GDP (Y): M × V = P × Y.Monetaristsargued that the central bank should follow a monetary policy rule to ensure that the money supply (M) grows at a certain rate over time. They argued that theinflation ratewas slow to change and predictable, so constant growth of the money supply would translate into steady growth of nominal GDP (P x Y). To see why this could be thecase, consider the fact that any time the left-hand side of the quantity equation, M × V, changes by a certain percentage, the right-hand side, P x Y, must change by the same percentage:Percentage Change in (M x V)Percentage Change in (P x Y)You can use a general rule about percentage changes to analyze changes in the variables of the quantity equation even further. The percentage change in the product of two variables is approximatelyequal to the sum of the percentage changes in each of the variables (as long as the percentage changes are fairly small). In the following equation, let '%A' stand for 'percentage change in':%AM + %AV%AP + %AYFor example, if you know that the money supply grows at a rate of 8% per year, velocity grows at a rate of 1% per year, and real GDP grows at a rate of 5% per year, you can use this rule to determinethat the percentage change in the price level is equal to 4% (%AM + %AV - %AY = %AP).Suppose the central bank subscribes to a monetarist approach to monetary policy. The central bank believes that the velocity of money grows at a predictable rate of 2% per year and that potential realGDP grows at 4% per year. If the central bank observes a monetary policy rule that stipulates money supply growth of 5% per year, it will expect an inflation rate of 11%per year and nominalGDP growth ofper year.Suppose that actual growth in the velocity of money unexpectedly rises to 2.5%. If the central bank continues to adhere to money supply growth of 5% per year and potential real GDP continues to growat 4% per year, the inflation rate will bethan anticipated, and nominal GDP growth will bethan anticipated.Which of the following events undermined the traditional monetarist case for a monetary policy rule based on money supply growth?Erratic changes in the velocity of money after 1980Erratic changes in the growth of potential output during the 1970sThe significant increase in the oil price in the 1970s

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