Question

1) Inflation – Chris Downs Much effort is made to keep inflation down. How severe a problem is inflation in reality?

2) Explain why a rise in the money supply will be unlikely to affect the real interest rate in the long run.

Answer 1

1. Inflation simply means the rise in the prices of goods and services in the economy. When there is a proportional change in all the prices and the wages, then inflation is rarely a problem. But this scenario doesn’t exist. The prices of the goods increase more as compared to the wages. For e.g. if inflation is 10% and wages also increase by 10%, then the inflation is irrelevant and this scenario doesn’t exist. If inflation is 10% and wages rise by 5% then the things become more expensive to us compared to the previous situation. This brings a decline in the real wages. And even investment falls, demand falls with a higher inflation rate. Hence when there is a higher inflation, the economic growth slows down. This is why economists suggest keeping the inflation level lower.

2. From the below given figure, money demand is MS1 and money supply is MS2 at the beginning. When money supply is increased from MS1 to MS2 there is a fall in the interest rate from r1 to r2. But this is a case of short run, in long run the interest rate remains unaffected, let us see how.

In long run, because of the increase in the price level there is an increase in the aggregate demand. Because when the price level is increased it means I’m paying more for the same goods, which means I need more money, and for this the demand for money curve MD1 shifts to the right MD2. Now when money supply is MS2 and money demand is MD2, the interest rate remains at same level i.e. r1. So the only thing that increases in the long run is the price level.

I MDA MSA Interest rate, r -MD Z MP4 O MS MS₂ Quantity of money