Question

Consider the equilibrium condition for the asset market    StartFraction Upper M Over Upper P EndFraction equals Upper L (Upper Y comma r plus pi Superscript e Baseline ). Using this​ condition, answer the following questions. A decrease in inflation ​expectations(pie​), with no change in​ output, real interest​ rate, or the money​ supply, will result in ▼ an increase no change a decrease in the price level. An increase in the nominal money supply ​(M​), with no change in​ output, real interest​ rate, or inflation​ expectations, will result in ▼ an increase no change a decrease in the price level. A decrease in output ​(Y​), with no change in the money​ supply, real interest​ rate, or inflation​ expectations, will result in ▼ an increase no change a decrease in the price level.

Answer 1

a. A decrease in expectations with no change in output, real interest rate or the money supply will result in a decrease in the price level. This is because inflation expectation is directly related to the price level. A anticipated decrease in inflation in the future means that suppliers will reduce their prices as they want more of the product to be sold. With a decrease in inflation (in the future), the prices in the future are expected to fall further.

b. An increase in the nominal money supply, with no change in output, real interest rate or inflation expectations will result in an increase in the price level. Mathematically, this can be explained by RHS=LHS in the equation above. If everything on the right hand side (RHS) remains constant, it means the left hand side (LHS) = M/P must also remain constant, that is, an increase in M would lead to an increase in P so that the ration M/P does not change. An economic explanation of the same is that with an increase in money supply ceterus paribus, people would be willing to pay more as their income would increase.