Question

Suppose a given country experienced low and stable inflation rates for quite some time, but then inflation picked up and over the past decade had been relatively high and quite unpredictable. Explain how this new inflationary environment would affect the demand for money according to portfolio theories of money demand. What would happen if the government decided to issue inflation-protected securities?

Short answer

Because of the inflationary climate, money demand is likely to shrink.

If the government provides inflation-protected assets as a substitute to risky money holdings, consumer spending will decline even lower.

Step-by-step solution

Step 1. Define demand.

Demand refers to the quantity of a product that customers are capable and willing to buy at various prices throughout a particular time period.

Step 2. Explanation

The demand for money would almost definitely diminish. Because money is more volatile than other assets, people would prefer to have more reliable assets and much less money. Furthermore, volatility and unpredictability of inflation would result in excessively high interest rates, limiting money demand. If the government provides inflation-protected assets as a substitute to risky money holdings, consumer spending will decline even lower.