Explain The Relationship Between Money Supply And Inflation - Essay Example

When money increases in quantity, the demand for it devalues consequentially. “According to Austrian Economics an increase in the money supply should result in inflation as the value of each old dollar is "diluted" by the printing of new dollars” (McMohan, 2009). Different theories of economy offer different explanation for the influence of money supply on inflation. According to the theory of quantity of money, which is often referred to as monetarism, relationship between the two terms is interpreted as MV = PT, where M = money supply, V = Money Velocity, P = Price Level, and T = Transactions (Ellis, 2011).

Other terms being constant, price level is controlled by the money supply. As the velocity of money and the transactions generally remain constant, this essentially means that increase in the supply of money directly increases the price. Likewise, decrease in money supply decreases inflation. On the other hand, the Keynesian theory suggests the existence of several other factors that can influence inflation and price level, in addition to the supply of money. “Generally, the Keynesian theory stresses the relationship between total or aggregate demand and inflationary changes” (Ellis, 2011).

Money supply is often varied to control the inflation. When the government intends to lower the inflation in a certain region, central banks stop lending the money frequently and raise the rate of interest. As a result of this, inflation drops. However, when it goes below the intended level, the lending patterns are loosed so that the economy may be stimulated. In other cases, when release of money becomes unreserved, it results into the situation of hyperinflation. When a bank issues loan, it adds to the amount of money in circulation, without a net increase in the wealth (Anon., n.d.). Economists mutually consent that an increase of inflation above 50 per cent per month is the symbol of inflation.

The inflation typically increases when the increase of money supply is not accompanied with an equivalent increase in the production of goods. In a vast majority of cases, the federal banking system is used to impose limits of the trends of lending and setting interest rates. If more money is supplied at equilibrium, it makes the interest rate ti go down because the supply of money far exceeds the demand (Hornle, 2007). In order to keep that from happening, the federal banking system decides the limits making use of the economic data.

Sometimes, it becomes hard to estimate the money supply, particularly when the trends changes constantly. The supply of money may increase frequently as a result of change in the patterns of storage of money on the part of people. The following chart displays the supply of money from 1985 to 2008. The per cent change in money supply of one year has also been shown: Supply of money vs inflation (McMohan, 2009). M1 is generally considered as the most accurate measure of supply of money in that M1 measures money in just its most liquid states.

M1 is just limited to the currency that is in the public’s occupancy in various forms which include but are not limited travelers’ checks, and checks for money deposits. Sometimes, increase in the supply of money may not cause the inflation to increase. Certain factors play a role in it that include but are not limited to the speed of circulation of money, increase in the capacity of productivity and the state of economy. Increase in real output is one