Discuss the effects of ongoing inflation based on the PPP theory. Wha

Discuss the effects of ongoing inflation based on the PPP theory.

What will be an ideal response?

ANSWER

Other things equal, money supply growth at a constant rate eventually results in ongoing price level inflation at the same rate as the money supply growth, but changes in this long-run inflation rate do not affect the full-employment output level or the long-run relative prices of goods and services.

The interest rate, however, is affected by continuing growth in the money supply (inflation). This can be shown by combining PPP with the interest parity condition. To show it analytically, recall that the condition of parity between dollar and euro assets is:
R$ = + ( – )/
And according to relative PPP:
( – )/ = ΠUS,t – ΠE,t
If people expect relative PPP to hold, the difference between interest rates offered by dollar and euro deposits will equal the difference between the expected inflation rates, over the relative horizon, in the U.S. and Europe.