How does money supply affect inflation?

Definitions matter when describing the relationship between changes in the money stock—or total money supply—and inflation. For example, the first definition of inflation given by the American College Dictionary is any increase in the currency not redeemable in specie. Other definitions consider inflation to be a general rise in the price of goods, which may or may not be directly related to the money supply.

Quantity Theory

The theory most discussed in the relationship between prices and the money supply is called the quantity theory of money. The quantity theory proposes the exchange value of money is determined like any other good, with supply and demand. The basic equation for the quantity theory, developed by American economist Irving Fisher, is expressed as: (total money supply) x (velocity of money) = (average price level) x (volume of economic transactions).

Some variants of the quantity theory propose that inflation and deflation occur proportionately to increases or decreases in the supply of money. Empirical evidence has not demonstrated this, and most economists do not hold this view.

A more-nuanced version of the quantity theory adds two caveats: New money has to actually circulate in the economy to cause inflation; and, inflation is relative, never absolute. In other words, prices tend to be higher than they otherwise would have been if more dollar bills are involved in economic transactions.

Challenges to Quantity Theory

Keynesian and other non-monetarist economists reject orthodox interpretations of the quantity theory. Their definitions of inflation focus more on actual price increases, with or without money supply considerations.

According to Keynesian economists, inflation comes in two varieties: demand-pull and cost-push. Demand-pull inflation occurs when consumers demand goods, possibly because of a larger money supply, at a rate faster than production. Cost-push inflation occurs when the input prices for goods tend to rise, possibly because of a larger money supply, at a rate faster than consumer preferences change.

(For related reading, see: How the Federal Reserve Manages Money Supply.)