What is the relationship between the money supply and inflation?

John Maynard Keynes.

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

During the interwar years in Germany, the government simply printed more and more bills to pay its bills, leading to hyperinflation.

Money supply and inflation are linked because a large amount of money often devalues ​​the demand for money. Imagine if everyone in a small town got a $50 US dollar (USD) raise in salary per month. These people may be paying $10 dollars a week for gas, but since their increase was substantial, they probably wouldn’t mind paying $11 dollars a week for gas now, because it’s still proportionately less than what they were paying before the increase. This is sometimes how the relationship between inflation and the money supply starts, when the market can support higher prices because the money supply has increased, but a consumer cannot buy a product at the price it was at before the inflation occurred, because the purchasing power of currency has eroded.

For the consumer, inflation lowers the value of money as the cost of what he buys increases.

The relationship between money supply and inflation is explained differently depending on the type of economic theory used. In quantity of money theory, also called monetarism, the relationship is expressed as MV = PT, or Money Supply x Money Velocity = Price Level x Transactions. Speed ​​and transactions are assumed to be constant, so according to this explanation, supply and prices are directly related. In Keynesian theory, while there is still a relationship between the money supply and inflation, it is not the only major factor that can affect inflation and prices. Generally, Keynesian theory emphasizes the relationship between total or aggregate demand and changes in inflation.

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The money supply and inflation are linked because a high money supply devalues ​​the demand for it.

Changes in the money supply are often used to try to control inflationary conditions. When a region is trying to reduce inflation, central banks often lower borrowing rates and raise interest rates. When inflation falls below a target, these standards are often relaxed in an attempt to stimulate the economy. Countries typically use a federal banking system to set borrowing and interest limits based on economic data.

The Federal Reserve constantly monitors inflationary risks to the US economy.

Unreserved increases in the money supply can sometimes lead to a condition called hyperinflation. This occurs when inflation jumps extremely high in a short period of time, although the exact definitions are somewhat variable. Economists often say that hyperinflation occurs when inflation rises by 50% in a month, but other estimates are also used. The money supply and hyperinflation are linked because the condition can result from a sudden, massive outpouring of money into an economy with no associated increase in the production or availability of goods. If, in the first example, city dwellers get a raise of $500 a month, the price of gas could suddenly multiply many times over, causing an extraordinarily high level of inflation.

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