Question

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.

Answer 1

a. Inflation is rise in general price level of an economy. According to quantity theory of money , MV= PT ,M=money supply ,P = price level, V= velocity of money circulation , T =transaction Money supply is directly related to price level. As money supply rises, price level also rise and as money supply declines price level also falls. Inflation can happen , if the money supply grows faster than economic output . An increase in money supply results in a decrease in the value of money because an increase in the money supply causes rate of inflation to increase. Monetary inflation is a sustained increase in the money supply of a country.

b. Suppose if an economy is already full employment equilibrium , then the increase in government expenditure leads to inflation in the economy. Because already economy achieved its potential output. An increase in government expenditure if an economy is at equilibrium, it would increase the aggregate demand for good and services. Thereby it increases price level in the economy. We know that economy is already at equilibrium. So increase in price level causes inflation . So inflation may be triggered by fiscal considerations.