A:

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.)

RELATED FAQS
1. ### What is the relationship between inflation and interest rates?

As interest rates are lowered, more people are able to borrow more money, causing the economy to grow and inflation to increase. ... Read Answer >>
2. ### What is the difference between Keynesian and monetarist economics?

Discover how the debate in macroeconomics between Keynesian economics and monetarist economics, the control of money vs government ... Read Answer >>
3. ### How Does Money Supply Affect Interest Rates?

Read about the link between the supply of money and market interest rates, and find out why money supply alone can't explain ... Read Answer >>
4. ### What happens when M2 money supply grows faster than the overall economy?

Find out what happens if the total supply of money and money substitutes expands at a faster rate than the productive output ... Read Answer >>
Related Articles
1. Insights

### What is the Quantity Theory of Money?

Take a look at the tenets, assumptions and challenges of monetarism's principal theory, the quantity theory of money.
2. Insights

### Cost-push inflation versus demand-pull inflation

Gain a deeper understanding of aggregate supply and demand, forces which raise the price of goods and services.
3. Insights

### 9 Common Effects of Inflation

Is inflation ever good? If you like your job it is.
4. Insights

### A Primer On Inflation

Inflation has a negative connotation, but is it all bad or does it offer some tangible benefits?
5. Insights

### Stagflation, 1970s Style

Find out how Milton Friedman's monetarist theory helped bring the U.S. out of the economic doldrums.
6. Insights

### Inflation's Impact on Stock Returns

Learn about the impact inflation can have on stock returns. Find information on what types of stocks perform during times of high inflation or low inflation.
RELATED TERMS
1. ### Quantity Theory of Money

The quantity theory of money is a theory about the demand for ...
2. ### Monetary Theory

Monetary theory is a set of ideas about how changes in the money ...
3. ### Cost-Push Inflation

Cost-push inflation is a phenomenon in which the general price ...
4. ### Time-Preference Theory Of Interest

The time preference theory of interest explains interest rates ...
5. ### Quantity Demanded

A term used in economics to describe the total amount of goods ...
6. ### Money Supply

The money supply is the entire stock of currency and other liquid ...
Hot Definitions
1. ### Quick Ratio

The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets.
2. ### Leverage

Leverage results from using borrowed capital as a source of funding when investing to expand the firm's asset base and generate ...
3. ### Financial Risk

Financial risk is the possibility that shareholders will lose money when investing in a company if its cash flow fails to ...
4. ### Enterprise Value (EV)

Enterprise Value (EV) is a measure of a company's total value, often used as a more comprehensive alternative to equity market ...
5. ### Relative Strength Index - RSI

Relative Strength Indicator (RSI) is a technical momentum indicator that compares the magnitude of recent gains to recent ...
6. ### Dividend

A dividend is a distribution of a portion of a company's earnings, decided by the board of directors, to a class of its shareholders.