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School of Economics ECO1011S Macroeconomics I Tutorial Solution 11 (Week 12) HOMEWORK (26 marks)

1.

If inflation cannot occur without money, does this mean that changes in the money stock always causes changes in inflation and that controlling the money stock is the only way to control inflation? (6) This question needs to be simplified to: What is the connection between money supply and inflation? This is the situation of monetary validation. Assume the economy starts off at some stable position (E0) along the LRAS (at Y*), but there is a shock to the system such that Aggregate demand increases (rightward shift). The economy is now in an unstable position since an inflationary gap opens up. If market forces are left to operate: the inflationary gap implies an excess demand for factors of production and over time the wage rate will start to increase. This increases the cost of production so the SRAS curve shifts leftward. If market forces were left to operate over time the economy would move to a new equilibrium back at Y* but now at a higher price level. This new equilibrium would be stable. If the interest rate is fixed at some level there is then another force operating in the economy through the money market. The higher price level caused by the original outward shift of the AD curve implies a higher demand for money. So Qd (of money) shifts outwards. So long as the interest rate is fixed the monetary authorities must allow money supply to expand outwards to meet the new Qd of money. This new increase in money supply now causes an additional effect on the AS-AD curve. As there is now “too much money chasing too few goods” which causes AD to increase. The new AD curve intersects the new SRAS curve. This point is not at Y* but at some point to the right of Y* (Y1). This maintains the inflationary gap