Question

1. Using separate graphs, demonstrate what happens to the money supply, money demand, the value of money, and the price level if:
a. the Bank of Canada increases the money supply. (6 marks)
b. people decide to demand less money at each value of money. (6 marks)

2. Economists agree that increases in the money supply growth rate increases inflation and that inflation is undesirable. So why have there been hyperinflations and how have they been ended? (5 marks)

Answer 1

1a. When the Fed increase the money supply in the system, it will shift the equilibrium by shifting the money supply to the right. It is shown in the graph below. When the money supply increases and the MS curve shifts to the right, the value of money decreases. As shown, the new money supply curve is MS' and the new value of money is V', which is lower than the earlier value. When the value of money is lesser, it holds to reason that the price level will rise.

alue ot Mone १s MS V Monty Pnव कunety of noou

1b. When people demand less money at each value of it, this decrease will result in lower value for the same money. It will shift the Money Demand (MD) curve to the left. Its shifting to the left will result in the new equilibrium value of money being lower than the earlier value, shown as V' in the graph below. The lower value of money will result in higher price level.

Nalue of My MS Puanbty of Monet

2. While economists do agree that inflation is bad, hyperinflation still occurs when a specific set of conditions is fulfilled. It usually happens in a situation where a country is spending more than its revenue generation (tax etc.) and it also does not have many option of borrowing the money from outside. So the government will start printing more money in order to bridge the gap between spending and revenue, resulting in continuously increasing money supply in the system, which will finally lead to hyperinflation.

Hyperinflation can only be solved by structural reforms, where the government increases taxes, reduces spending and increases borrowing options by reforms such as opening up the economy.