Inflation affects the real economy in two specific areas: it can harm economic efficiency, and it can affect total output. We begin with the efficiency impacts:- Inflation impairs economic efficiency because it distorts prices and price signals. In a low inflation economy, if the market price of a good rises, both buyers and sellers know that there has been an actual change in supply and/or demand conditions for that good, and they can react appropriately. By contrast in a high inflation economy, its much harder to distinguish between changes in relative prices and changes in the overall price level. Inflation also distorts the use of money. Currency is money that bears a zero nominal interest rate. If the if the inflation rate rises from 0 to 10% annually, the real interest rate on currency falls from 0 to -10% per year. There is no way to correct this distortion. As a result of the negative real interest rate on money, people devote real resources to reducing their money holdings during inflationary times. They go to the bank more often. Corporations set up elaborate cash management schemes. Real resources are thereby consumed simply to adapt to a changing monetary yardstick rather than to make productive investments . Effect of GDP on Money Supply
Money supply and GDP do not automatically affect each other, but Money Supply can affect GDP depending on monetary policy; the expressed intention in economic management is to monitor the money supply to allow transactions to take place. Therefore, if money supply is severely restricted it is likely to affect the GDP: i.e.: reduce the volume of transactions . The GDP can only increase the demand of money... and transactions will stall if that demand is not met. GDP is also inadequate as a measure of real production, because it does not truly represent production, but it is a statistic of dollar value of all transactions that have taken place. A comparison of the two statistics maybe valuable after the fact to...
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