Question

B. Since 2007 (quant. easing), many non-Keynesian economists (Classical) have been predicting a rapid increase in the inflation rate. Why? Use the equation in your answer.

Answer 1

According to the classical economists the price level will tend to increase with an increase in money supply. As quantitative easing is an increase in the money supply by increasing currency in circulation and printing more money, according to them as the money supply increases, there is more cash in the hands of the public, this leads to greater demand for goods and services and thus prices of commodities and services tend to rise as there is a greater demand in the economy.

Also as money supply increases, the value of the currency reduces as there is more in circulation, thus $1 worth of currency is less valued and is able to buy less number of goods.

The classical economists have propounded the quantity theory of money where the general price level of goods and services tends to be proportional to the level of money supply in the economy. Thus greater the money supply, greater the price level and thus a rapid increase in inflation rate.

M * V = P * Q

Where M is the money supply, V is the velocity of money, P is the price level and Q is the quantity of goods sold in the economy.

Thus as the money supply increases for example by 15%, the nominal GDP which is P * Q will also tend to increase by 15%.