Question

Question Six “Inflation is always and everywhere a monetary phenomenon”. Milton Friedman’s famous quote has an important implication in Monetary Economics. With regards to this quote: a) Discuss the relationship between money and inflation. b) What is the effect of money supply on interest rates? Explain. c) Discuss the role of the foreign exchange market in an economy. d) Distinguish between demand-pull and cost-push inflation.

Answer 1

a) Rise in money supply raise inflation rate or we can say that there exist a positive relationship between money and inflation rate because rise in money supply raise willingness to pay by consumers and raise cash holdings with them. Rise in aggregate demand will shift demand curve to its right from AD to AD1 which raise price level from P to P1.

b) Rise in money supply will reduce rate of interest because people will not need loans from any source. It will shift LM curve to its right from LM to LM1 which will reduce rate of interest from "i" to "i1".

c) Foreign exchange rate directly affect net exports. Depreciation of domestic currency in exchange of foreign currency will make domestic goods cheaper in exchange of foreign goods which will raise demand of domestic goods and raise exports while appreciation on other hand will raise imports and reduce net exports.

d) Demand pull inflation occurs when there is increase in demand while supply remains same which raise price level while cost push inflation occurs when there is rise in cost of production which induce producers to reduce their supply which raise price level.