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Q. Discuss the effects of ongoing inflation based on the PPP theory.
Answer: Other things equivalent 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 don't affect the full-employment output level or the long-run relative prices of goods and services.
The interest rate though is affected by continuing growth in the money supply inflation. This is able to be shown by combining PPP with the interest parity condition.
To demonstrate it analytically recalls that the condition of parity among dollar and euro assets is.
Interest rate in the United States is equivalent to interest rate in the euro countries plus expected depreciation of the dollar.
as well as according to relative PPP-
(E$/Et - E$/E,t-1)/E $/E,t-1 = Inflation rate in the United States less inflation rates in the euro countries.
If people anticipate relative PPP to hold the difference among interest rates offered by dollar and euro deposits will equal the difference among the expected inflation rates over the relative horizon in the Europe and U.S.
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