Question

Analyzing hyperinflation using the forex and money market model. Hyperinflation is caused by large continuous increases in money growth rate and as a result, prices become quite flexible even in the short run. Suppose there is an increase in expected inflation rate and current prices outpace the increase in money growth rate (so what happens to real money supply?). What is the implication on nominal interest rates and the current exchange rate? Draw the diagram and show the initial and final equilibrium in the short run. Describe the process of going from one equilibrium to another equilibrium.

Answer 1

Real money supply increases in such circumstance. When there is inflation , and prices are more than increase in money growth rate it means that money supply increases. An increase in money supply causes prices to rise ie inflation because more money is in circulation and there is decrease in the value of money .This is because there is more money but quantity of goods is the same.

An increase in money supply lowers the nominal interest rate and so it becomes less expensive for consumers to borrow..An increase in money supply will cause depreciation in the current exchange rate.This is because increase in money supply increases inflation and lowers nominal interest rate . So there is depreciation in exchange rate.

Initial equilibrium is a E as shown in the diagram and final equilibrium is at E1 as shown in the diagram .

As a result of increase in the money supply the supply curve shifts to the right.Nominal interest rate falls to i' from i.There is depreciation in the exchange rate as well