Question

The government of a country increases the growth rate of the money supply from 5 per cent per year to 50 per cent per year.

a.) what happens to prices?

b.) what happens to nominal interest rates?

c.) why might the government be doing this?

Answer 1

A) as per growth version of quantity theory of money.

%∆ in M = %∆ in prices ( inflation rate) +%∆ in Y

So if money velocity is constant, then inflation will increase dramatically , a situation of Hyper inflation.

B) as Accordingly to Fisher effect :

Nominal interest rate (i ) = real interest rate (r) + inflation rate

As inflation rate has increased , so nominal interest rate will also rise dramatically

C) govt might be resorting to deficit financing, printing the current currency in order to finance it's expenditures, due to which money supply has to be increased by a huge amount