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Q. Explain money market with inflation?
The money market with inflation
Let's begin with the money market diagram and introduce inflation. As MD relies positively on P, MD curve to 'glide' out towards the right when inflation is positive and toward the left when we have deflation.
Figure: The money market with inflation and constant money supply
If money supply is constant, nominal interest rate would continuously increase when we have inflation and continuously decrease when we have deflation.
An interesting special case is when money supply increases by same rate as P. In this case, money supply curve would also glide outwards or inwards (depending on whether we have deflation orinflation) at exactly the same rate as money demand. Nominal interest rate will then be constant.
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