Question

13. Suppose the Federal Reserve increases the U.S. money supply in an effort to prevent the U.S. economy from slipping further into recession.

a. According to the Quantity Theory of Money, what will the increased money supply do to the price of goods in the United States in the long run, all else equal?

b. According the theory of PPP, what will happen to the exchange value of the U.S. dollar as a result, all else equal? In particular, would you expect the dollar to appreciate or depreciate against foreign currencies?

c. According to PPP, what will happen to the real cost paid by foreigners for U.S. products?

Answer 1

a) When the money supply increased in the economy, and according to the quantity theory of money , the price of goods also increase because accoridng to the quantity theory of money, when the money supply doubles , the price level also doubles. Therefore, when the money supply increase we can say the price level also increase and hence inflation rises.

b) According to the theory of PPP, the exchange value of the U.S dollar will depreciate against foreing currencies because according to PPP theory, the countires which have higher rates of infaltion will generally have devalued currency. so U,S dollar will depreciate .

c) According to PPP , the real cost paid by foreigners for U.S products will decrease because the U.S dollar is depreciated and foreigners can buy more dollar from 1 units of thier currency.