Question

- Define Classical Theory of inflation; Classical Dichotomy: how nominal and real variables are affected by changes in money supply in the long run? In the short-run? Define and bring examples of nominal and real variables.  

- What factors cause real exchange rate to rise? What does real exchange rate appreciation (depreciation) imply for net exports? Why?

Answer 1

Classical theory of inflation - As per this theory money is the assets which is utilise by people to purchase goods and services regular basis.as we know inflation happens when overall prices increases and demand increases.

The supply of money is dominant influence on nominal income.when we talking about long run the influence of money is primary on price level.hence in the long run real variable like output and employment are determined by real .its not determined by monetary factors.

While in the short run supply of money does influence real variables.money is dominant factor causing movement in output and employment.

Real variable means those variable where the effects of prices and inflation have been taken out.example -real gdp ,real wages.

While nominal variable means when the effects of inflation have not been controlled.example - wages,income and nominal gdp

Factors that causes real exchange rate to rise is-

Inflation rate- when there is changes in the inflation then it also affect real exchange rate.trade terms also affected real exchange rate.interest rates changes,public debts,speculation activity also affected real exchange rates.

When there is increase in real exchange rate then it means people in a country get more foreign goods for an equivalent amount of domestic goods.and if there is fall in exchange rates then it means net exports are increasing because domestic goods become more competitive.