Explain The Relationship between money supply and inflation - Essay Example

Since high inflation rate decreases the nominal value of money, demand for money decreases (Gafar 2003, p. 101; International Monetary Fund 1996, p. 106). This makes demand for money less sensitive to high inflation rate (Sussman and Zeira 2003). High inflation could impede the overall economic growth in UK. Each time UK is facing high inflation rate, it is expected that the real value of money decreases. At this point in time, abundant supply of money circulates in the entire UK economy. For this reason, the prices of local goods and services tend to increase.

Since the nominal value of money decreases, interest rates and minimum wage requirements could increase (International Monetary Fund 1996, p. 101). In order to control the adverse economic effect of high inflation rate, monetary policy should be use in order to control the supply of money that circulates in UK. To allow the readers have a better understanding about this subject matter, this report will focus on discussing the relationship between money supply and inflation. After discussing the relationship between money supply and inflation, this report will discuss how increasing or decreasing the interest rate could affect the increase or decrease in money supply.

Relationship between Money Supply and Inflation In general, central banks do not have a direct power to improve economic growth. Given that money supply has a significant role in the movements of inflation rate (Basco, D'Amato and Garegnani 2009), central banks control the money supply by manipulating the levels of short-term interest rates at the point wherein the central banks could control high inflation rate from increasing (Gafar 2003, p. 103). Specifically in the case of European Union, the European Central Bank (ECB) was made responsible in keeping the market prices of basic commodities stable by preventing inflationary growth (Hossain 2010).

High inflation rate contributes to low economic growth as a result of increasing the interest rates and minimum wage requirements (Gafar 2003, p. 102). Since the market price of basic commodities is high at times when inflation rate is high, more people will have difficulty in purchasing basic commodities. Because of high minimum wage requirements, more local businesses will not be able to sustain its daily operational costs in times when sales are down (Laing, Li and Wang 2007). To avoid bankruptcy, a large number of the local businesses are likely to cut down the number of its employees.

In the end, this increases the unemployment rate. Monetary equation assumes that a significant increase in the supply of money could result to a significant increase in price provided that velocity and Y are constant [MV = PY]. In line with this, several studies revealed that the velocity of money is highly correlated with growth in money supply under high inflation and vice versa (Basco, D'Amato and Garegnani 2009; Dwyer and Fisher 2009). As part of controlling the money supply, ECB reported that it is necessary to maintain the Harmonized Index of Consumer Prices (HICP) “below but close to 2% inflation rate” (ECB 2007b; ECB 2003).

Maintaining inflation rate close or below 2% inflation rate is necessary to ensure that the EU economy will benefit from stable market prices. Likewise, keeping the inflation rate below or close to 2% inflation rate could protect the EU economy from the risk of having