Question

Macroeconomic question

1."An increase in the money supply will always be inflationary and cause prices to rise" true or false? illustrate and explain and be sure to distinguish between the short run and the long run.

2.illustrate and explain the shape of the interest sensitive demand for money function including what is involved in a movement along versus a shift in the function.

3.if the bank of Canada sells some of its holdings of bonds to the chartered banks, the bank will use some of their reserves but in doing so it will add to the money supply (true or false?) Explain your answer.

Answer 1

The statement "An increase in the money supply will always be inflationary and cause prices to rise" is True.

The reason is the validity of Friedman’s Quantity Theory of Money. To Friedman inflation is always a monetary phenomenon. This statement has been proved many times empirically that whenever countries experience very high inflation for a long period of time, those countries also experience a rapid increase in the rate of growth of their money supply.

In the short time period, increased money supply leads to increases in output. In this period, increased volume of money supply causes the nominal rate of interest to decrease which in turn increases investment and real output. However, according to the automatic correction mechanism, the accompanying inflation will finally lead the aggregate supply volume in the short time period decreased. The decreased aggregate supply volume returns the economy to the full employment situation and a new and permanent price hike. It means if the money supply growth occurs faster than the grown output volume, the only place for that increased money supply to go is the price level.

In the long time period, increased money supply just causes inflation. According to Friedman, money is neutral. That doesn’t mean that changes occurred to money supply have no impact. Rather, neutral means that changes occurred to money supply have no impact on one variable in particular i.e. real output. In the long time period, real output will depend on resources and technology, not the money supply. This means that changes occurred to the price level and therefore the inflation rate depends basically on changes occurred to the money supply.