How Does Money Supply Affect Inflation?

Inflation can happen if the money supply grows faster than the economic output under otherwise normal economic circumstances. Inflation, or the rate at which the average price of goods or services increases over time, can also be affected by factors beyond the money supply.

The theory most discussed when looking at the link between inflation and money supply is the quantity theory of money (QTM), but there are other theories that challenge it.

Quantity Theory

The quantity theory of money proposes that the exchange value of money is determined like any other good, with supply and demand. More specifically, the QTM proposes that the exchange value of money is determined by the volume of transactions (or income) and the velocity of money in the economy. The conceptual basis for the quantity theory was initially developed by the British economists David Hume and John Stuart Mill.

The basic equation for the quantity theory is called the Exchange Equation, or by some as the Fisher Equation because it was developed by American economist Irving Fisher. In its simplest form, it looks like this:

$\begin{aligned} &(M)(V)=(P)(T)\\ &\textbf{where:}\\ &M=\text{Money Supply}\\ &V=\text{Velocity of circulation (the number of times }\\&\text{money changes hands)}\\ &P=\text{Average Price Level}\\ &T=\text{Volume of transactions of goods and services}\\ \end{aligned}$​(M)(V)=(P)(T)where:M=Money SupplyV=Velocity of circulation (the number of times money changes hands)P=Average Price LevelT=Volume of transactions of goods and services​

If the equation of exchange is rearranged to solved for the level of prices, then: P=MV/T, suggesting the price level increases with the supply of money, the velocity of money, and inversely with the volume of transactions (real income).

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 the 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.