Money Supply And Inflation

Inflation refers to a sustained rise in the prices of goods and services. When inflation occurs, the buying value of a currency unit erodes, meaning that a person needs more money to buy the same product. Most economists suggest there is a direct relationship between the amount of money in an economy, known as the money supply, and inflation levels. Understanding the relationship between money supply and inflation is far from easy or predictable, since inflation can easily be influenced by other factors as well.

The relationship between money supply and inflation is explained differently depending on the type of economic theory used. In the quantity of money theory, also called monetarism, the relationship is expressed as MV=PT, or Money Supply (the amount of money in circulation) x Velocity of circulation (the speed with which money flows round the economy)=Price Level x Transactions or output. The Velocity and Transactions are considered to be constants, so according to this explanation, supply and prices have a direct relationship. MV represents supply of money and PT represents demand for money. Assuming V and T are constant, price level varies in direct proportion to the quantity of money. If supply of money increases, there is inflation or rise in prices. In Keynesian theory, while there is still a relationship between money supply and inflation, it is not the only large factor that can affect inflation and prices. Generally, the Keynesian theory stresses the relationship between total or aggregate demand and inflationary changes.

For example, assume a very small economy that has a money supply of Rs.50 and only two people i.e., Farmer and Mechanic. Farmer goes to Mechanic for getting his tractor repaired and paid Rs. 50. In turn, Mechanic purchases rise worth of Rs. 40 from Farmer. After few months, again Mechanic purchases maize worth of Rs. 10. These are the transactions taken place in our imaginary economy in a year.

M = Money supplied, V = Velocity ( The rate at which money is exchanged from one transaction to another), P = Average general price, T = No. of transactions.
MV = Total money supply; PT = Value of all the transactions (Value of goods and services produced, i.e., GDP)

If money supplied is increased by 100%, then price level also increases by 100% when V and T are constant.

Changes in money supply are often used to try and control inflationary conditions. Central bank will generally lower lending rates and increase interest. When inflation drops below a target level, these standards are generally relaxed in an attempt to stimulate the economy.