Question

What is the meaning of this statement? "Government policy determines whether the rate of growth in a country's money supply is greater than the rate of growth in output. A government can increase the money supply simply by telling the country's central bank to issue more money."

No graphs please. I need a detailed explanation

Answer 1

Solution

PPP theory predicts that changes in relative prices still result in a change in exchange rates. theoretically, a country in which price inflation is running while should expect to see its currency depreciate against that of countries in which inflation rates are lower. if we can predict what a country's future inflation rate is likely to be, we can also predict how the value of its currency relative to others. its exchange rate is likely to change. the growth rate of a countrys money supply determines its likely future IR. we can use info about growth in money soppy to forecast exchange rate movements. increase in money supply makes it easier for banks to borrow from the gov and for individuals and companies to borrow from banks. resulting increase in credit causes increases in demand for goods and services. unless output is growing at rate similar to that of money supply, result will be inflation. when the growth in a country's money supply is faster than the growth in its output, price inflation is fueled. PPP tells us that a country with a high inflation rate will see depreciation in its currency exchange rate. Bolivia experienced Hyperinflation (an explosive and seemingly uncontrollable price inflation in which money loses value very rapidly). Another way of looking at the same phenomenon is that an increase in a country's money supply, which increases the amount of currency available, changes the relative demand-and-supply conditions in the foreign exchange market. If the U.S. money supply is growing more rapidly than U.S. output, dollars will be relatively more plentiful than the currencies of countries where monetary growth is closer to output growth. As a result of this relative increase in the supply of dollars, the dollar will depreciate on the foreign exchange market against the currencies of countries with slower monetary growth.Government policy determines whether the rate of growth in a country's money supply is greater than the rate of growth in output. A government can increase the money supply simply by telling the country's central bank to issue more money. Governments tend to do this to finance public expenditure.A government could finance public expenditure by raising taxes, but because nobody likes paying more taxes and because politicians do not like to be unpopular, they have a natural preference for expanding the money supply.