Determination of Money Supply and the Relationship between Money Supply and Inflation - Research Paper Example

Determination of Money Supply and the Relationship between Money Supply and Inflation: A Comparative Case Study between UK and EU Market Instructor Unit Date Abstract There is correlation between money supply and inflation in an economy. An economy can either be operating normally, can be in a depression or can be recovering from a depression. Using the case of United Kingdom and the European markets, this research finds that there are the three periods of an economy will be affected differently by money supply in terms of the price of commodities. There is a correlation between money supply and price as provided by the monetary exchange equation. An increase in the money supply for a normal economy results to an inflation if the increase in the money supply is far much beyond the increase in real output. On the other hand, for an economy that is depressed, an increase in money supply does not cause any inflation. Finally, A recovering economy will result to an inflation if the money supply is increased. Introduction The dynamics of the monetary assets in an economy over at a specified time has been an issue with many governments in the world today. On the other hand, the aspect of controlling prices remains a major macroeconomic concern for economies. Money is the most widely used and universally acceptable medium of exchange. It affects many aspects of the economy. It has been paramount for countries to develop monetary policies that will facilitate the stability in money supply. The monetary policies have a capacity of controlling money to various degrees, there are the narrower measures that are easily and directly affected by monetary policy, and on the other hand, the broader measures are influenced in a lesser way by the actions of monetary policies. Based on these categories, there are six classes of money; M0 (narrowest), MB, M1, M2, M3, and MZM (Salmon 1995). Money supply is a predictor of inflation. Through the equation of exchange or the equation for demand of money, it is possible to predict the economic behavior in an economy. The Central Bank of each country has the responsibility of regulating the supply of money hence keeping inflation on check. Inflation results in rise of prices of commodities. However, the dynamics of the influence of money supply on inflation is a macroeconomic concept that is not straightforward. In this research, I endeavor to establish the relationship between money supply and inflation. I will base my argument drawing a comparison between the European Union market and that of the United Kingdom. Based on the available literature, I will explore the precise meaning of money supply and inflation in the first section. On the second section, I shall develop a clear link of these two macroeconomic concepts and relate them with the EU and UK markets. Finally, I will analyze the findings and draw appropriate conclusions. Background Literature Money Supply Money has conventionally been perceived as a medium of exchange. However, with structural changes in the economy characterized by changing regulations as well as innovations, the basic function of money has continued to evolve. Many economists agree with the definition of money, which establishes that, it is the total currency in circulation and the demand deposits that are held in the banks. Money supply refers to the amount of monetary assets (in circulation and demand deposits) that is available at a specified time in an economy. The central bank is the body that has the sole mandate of recording and publishing information that relates to money supply in a given economy. The supply of money has consequences over the a number of aspects in an economy, such as the exchange rate, inflation, prices as well as the business cycle. Inflation It relates with increase of prices in monetary form in an economy. The economy experiences a persistent rise in the price level of commodities resulting to reduced number of goods and services that can be acquired through a given unit of currency. This translates to a significant reduction in the purchasing power that a unit of the money in the economy can buy. Inflation is also an indicator that the currency in use declines in its value. The general percentage change in the consumer price index, also called the inflation rate is the actual determinant of price inflation. Inflation is more deleterious compared to the benefits that come forth. It has a potential of derailing future investments while the level of savings declines, shortage of goods resulting from hoarding by the consumers and the opportunity cost of holding money increases exponentially. All these have the potential of causing an economic decline. Relationship between Money Supply and Inflation Inflation is a macroeconomic aspect that can emanate from composite factors. One of the major factors that have the capacity of contributing to inflation is the amount of the money assets that are available in an economy over a given time (Money supply). However, the relationship is not straightforward and hence cannot be sufficiently determined because of the multiple factors that affect inflation. Supply and demand dynamics affects the value of money in an economy. Monetary assets in high supply have an effect of reducing the value of the demand for money. This forms the basis of inflation. The erosion of the buying power of a given currency as a result of inflation is a factor of the amount of money that is in supply (Salmon 1995). Various theories are used to explain the relationship that exists between money supply and inflation. One of the major theories in the quantity of money theory. Others include the Keynesian theory. The monetary exchange equation was established by Irving Fisher and has been used to relate money supply with inflation. Monetary Exchange Equation This equation establishes the relationship between price level and the supply of money. In addition, it can also be used to define the relationship between money and nominal Gross Domestic Product. The equation appears as shown below; M*V=P*Q where; M= Money supply V= Velocity of money P= price level Q= Real output (quantity of goods, services, and assets sold in a given year) Each of these components can be established in order to construct a relationship between the two parameters. The velocity of money entails the number of times each dollar is spent in a year. It can be easily calculated through the restricting of the equation as follows; V=PQ/M Twisting the equation, we establish that the total amount that is spent in an economy (MV) should be theoretically equal to the colossal amount in sales revenue (PQ), that is; MV=PQ PQ equates to the nominal GDP, an aspect that reveals that the expenditure in an economy (MV) equates to the nominal GDP. This forms the basis of the relationship between money supply and the price level, an indicator that changes in the money supply causes a change in the price level as shown below. PQ= Nominal GDP Therefore; MV=Nominal GDP MV=PQ P= (MV)/Q This equation shows a direct relationship between the price level and the money supply; hence, it can be used to predict the effect of money supply on inflation. Aberration from the Theory In practical terms, not all circumstances of increased money supply results to increased inflation. Factors such as the economic growth of the reproductive capacity, the overall state of the economy as well as the velocity of circulation have an influence on inflation too. However, other factors can also influence inflation. Firstly, when an increase I money supply is accompanied by an increase in the real output, then inflation does not occur. An increase in real output can result from the increase in the aggregate demand accompanied by an increase in the productive capacity of the economy; hence there occurs no inflation despite the increase in money supply (Waingade 2011, P. 29). This is because the money supply will grow with the real output in order to maintain the price level. The only time an inflation will occur is when the rate of growth of money supply surpasses that of the real output. Secondly, it is difficult to measure money supply accurately due to the dynamics that are involved. Money supply keeps on changing now and then, therefore, keeping track becomes difficult. Thirdly, the assumption that the velocity of money is a constant is erroneous because it keeps on changing when applied in practical terms. Finally, the Keynesian view mentions that an increased money supply in a recession is helpful in facilitating the use of the unemployed resources. Such an increase in money supply is unlikely to cause inflation. Money supply and inflation in UK The United Kingdom has two ways in which they measure their money supply. There is the ‘narrow money’ and the ‘broad money’. The M0 (narrow money) refers to all the money that is found outside the Bank of England and the M4 entails the money that is found outside the banks. Concerning liquidity, M0 is liquid while M4 is illiquid. There has been dynamics in the money supply in UK, an aspect that has signaled growth in economy or an increased inflation. Using M4, it is possible to identify the overall growth of the economy and hence be able to identify inflation. M4 is a good indicator of a recession; in 2008, M4 reached a low of registering a negative growth, the same has been translated to the yester years, 2011 and 2012. Due to the negative broad money supply, inflation has continued to hit UK markets hard. It defies the exchange equation when there is a negative growth rate of money supply while the inflation rate is on the rise. However, According to the Bank of England (2013), there are five reasons why this is the case. Firstly, factors such as taxes, the prices of raw material, cost push factors and higher imported prices plays a pivotal role in pushing the inflation high. Secondly, economic depression coupled with decreased investment results in the inflation despite the reduced money supply. Thirdly, there is an increased saving rate. Fourthly, there is limited consumer confidence that is aggravated by weakened banks. Finally, historically there has been a poor relationship in the United Kingdom between money supply and the inflation rate. Money supply and inflation in EU The European Union monetary mandate is under the jurisdiction of the European Central Bank. Contrary to the case in the United Kingdom, EU has three measures of money supply; these are, M1 which includes the all the overnight deposits in addition to the amount of currency in circulation. Then we have M2, which includes M1, and deposits that can be redeemed after 3 months plus deposits that mature for up to two years. On the other hand, M3 encompasses M2 and all the debt securities that can last for up to two years in addition to money market funds and purchase agreements (Dennig 1998, pg 299). Since the beginning of 2010, there has been a reduction in the M1 in the European Union territory. In this case, the economic growth appears to be slow and the price of commodities is anticipated to remain constant. In addition, there has been a declining growth in M3. Another predictor that economic activities within this region are dwindling. The prediction that the situation is not as a result of inflation but deflation should be the key aspect that should be clearly focused on. In essence, there are underlying reasons why there is the fall. Economists have pointed various aspects as potential contributors to the economic situation in the EU. Firstly, the economies in this block have depicted results showing poor economic trend especially in France and Germany. There has been a reduction in the spending rate among most of the euro countries. Thirdly, the Euro has been very strong against the dollar. Fourthly, they have pointed slow economic growth that has been experienced globally. Fifthly, there has been an increase in the interest rates by the European Central Bank. Finally, there has been a drastic reduction in the consumer confidence due to the economic challenges in the region (Mehrotra, and Slacik 2009). Findings This research has established that money supply is an important aspect that plays a critical role in predicting the inflation in an economy. However, the findings also establish that it is not the only aspect that plays a role in determining inflation. The monetary exchange equation is the tool that is used to predict the relationship between inflation and money supply. In theory, it has been used by the central banks to determine the trend of the economy. Despite its importance, in practical terms, it is not truly the case; some aberrations do occur. There are three main connections between the supply of money and inflation. Firstly, when the economic situation is normal, there will occur an inflation if there occurs an increase in money supply beyond the rate of increase of the real output. Secondly, when the economy is in a recession, there occurs a reduction in the velocity of circulation; hence, the money supply can be raised without an accompanying inflation. Finally, when there occurs an economic recovery resulting to an increase in the velocity of circulation, an increased money supply is likely to cause inflation. Conclusion Money supply is capable of causing inflation depending on the state of the economy. If the economy is normal money supply increment beyond the rate of increase of the real output, inflation will occur. If the economy is in a depression, then an increase in money supply will not cause inflation. Finally, there is likelihood of inflation if the money supply increases when the economy is in a recovery phase. References Bank of England (2013), A Money and Lending, retrieved on 24 February, 2014 from http://www.bankofengland.co.uk/boeapps/iadb/index.asp?first=yes&SectionRequired=A&HideNums=-1&ExtraInfo=false&Travel=NIxSTx Waingade, R.A (2011), "Money Supply and Inflation: A Historical Analysis", IUP Journal of Monetary Economics, vol. 9, no. 1, pp. 22-45. Dennig, U (1998), "Problems of measuring the money supply in the Euro area", Intereconomics, vol. 33, no. 6, pp. 299. Senn, P.R. 1999, "Monetary policy and the definition of money Implications for the European Monetary Union", Journal of Economic Studies, vol. 26, no. 4, pp. 338-382. http://search.proquest.com/business/docview/220656739/450511E186854FB7PQ/2?accountid=45049 Salmon, C (1995), “Influences on Broad Money Growth,” Bank of England Quarterly Bulletin, Vol. 35, February, 46-53. Mehrotra, A. 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