Suppose there is a large increase in the money supply in an economy that previously had low inflation. As a consequence, aggregate output expands in the short run. What does this say about situations in which the classical model of the price level applies?

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Business

Howard Greer

27 July, 03:06

Suppose there is a large increase in the money supply in an economy that previously had low inflation. As a consequence, aggregate output expands in the short run. What does this say about situations in which the classical model of the price level applies?

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Edith Cooley · Answer 1

It illustrates that the classical model of the price level best applies to economies with persistently high inflation.

Explanation:

When a very low inflation rate has been constant in an economy, and the money supply increases suddenly, in the short run that change will not immediately increase the inflation rate, but instead it will increase real output.

Classical economists argue that an increase in the money supply will immediately affect the inflation rate, but that theory applies mostly to economies that have a certain level of inflation. For example, for the past 12 years, European nations have been experiencing very low inflation rates, sometimes even negative rates. But during that same period, the European Central Bank has carried on a huge expansionary policy. It favored economic growth, although not as much as expected, but it didn't skyrocket inflation rate as the classical economy model predicted.