Explain the relationship between money supply and inflation - Essay Example

money supply and the level of inflation within a specific period of time. Link between money supply and inflation Trying to relate money supply to inflation is not as direct as it sounds as numerous factors also play significant roles in predicting or measuring inflation (Mankiw 2008). However, the link between money supply and inflation is easily explained as a near natural occurrence since when money is in high supply within an economy the demand for it reduces. In this scenario the market is able to afford higher prices for commodities because money supply has increased.

At the same time the consumers are not able to revert back to the old prices as long as the buying power of their currency is still under value erosion. Economic theories Economic theories also affect how this relationship is explained. The monetarism theory for example, expresses the relationship in the form of MV = PT which translates to; M = Money Supply V = Money Velocity P = Price Level T = Transactions In this scenario transactions are constant just as velocity is while supply and prices are directly related (Browne and Cronin 2010).

The fundamental argument set forth by monetarism theory is that rising money supply leads to inflation in the situation that the rise in the former exceeds growth of the National Income. It is still under this that T = Transactions is replaced with Y = National Income in many occasions as near-accurate measurements of the former always prove to be difficult. The new equation derived therefore reads; MV = PY. According to Bernanke and Woodford (2006), one notable proponent of monetarism, Friedman stated that ‘… inflation is always and everywhere a monetary phenomenon’.

Further arguments state that inflation is generally as a result of uncalled-for swells in a nation’s money supply. In respect to velocity, monetarists claim that it is fixed and if it varies the variants are insignificant. The same case applies to the output which is represented by Y and both V and Y are fixed in the short term. An example lies below; When MS = $2,500 and V = 4 ----- Y = 10,000 units Eqn. 2,500*4 = 10,000 With doubling of MS comes doubling of price level as elaborated below; 5,000*4 = 20,000 In the above scenarios Friedman stated that increase in MS takes between 9 to 12 months to result to increased output (Gwartney, Stroup, Sobel and MacPherson 2008).

He further stated that it is after another year that output will be at equilibrium with increase in prices to put up with already high money supply. AD & AS model (Hornle 2008) When considering aggregate demand and supply model it is clear to see that when there is increase in money supply there will be increased spending. This will essentially result to a shift of the Aggregate Demand to the right (Hornle 2008). In this scenario producers then engage more of their resources in order to meet the rising demand.

The resultant effect is an increased national output that is beyond the equilibrium level causing an inflationary gap in the economy. With increased production producers enrol more employees therefore increasing their expenditure. In this scenario workers are willing to work for longer periods as there is a corresponding rise in their nominal wage. With continued increase in prices money loses value and a movement is witnessed along the newly formed Aggregate Demand (Woodford 2008). It is at this