1) In a paragraph, describe how fiscal deficits can cause hyperinflations. Use the quantity theory to help frame
your discussion. (12 points)

 

According to the quantity theory of money, price level and money supply in an economy are in direct proportion to one another. In a scenario where there is a  change in the supply of money, there is a proportional change in the price level and vice-versa. Similarly, higher government deficits result to higher money growth in the current period as well as in the future, thereby leading to inflation. In economies where money creation is the only way to finance government budget deficits, it become a principal determinant of money growth and inflation. Fiscally-dominant governments with sizable debts and unstable fiscal positions will definitely experience hyperinflation. When the fiscal authority is passive, and the public expect prices to rise, they will  spend their money balances at a faster rate increasing the velocity of money, which can in turn produce hyperinflation.