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There are different views on the causes of inflation. While the standard view is that inflation...

There are different views on the causes of inflation. While the standard view is that inflation is a monetary phenomenon, others emphasise the impact of fiscal policy.

a. Explain how inflation is related to the money supply according to the quantity theory of money. Motivate your answer using equations.

b. Explain how inflation may be triggered by fiscal considerations, e.g. a desire to increase government spending. Motivate your answer by formulating the government’s budget constraint.

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Answer #1

A) Accoridng to Quantity theory of money MV=PY and here Y is real income which is equal to full employment output and P is the price level. Thus there is one to one relationship between price and money supply.Thus Any increase in money supply will directly lead to inflation

B)Increase in govt. spending will increase the aggregate demand where supply curve will remain same. Thus an increase in aggregate demand will shift the demand curve rightward leading to an increase in price

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