How Does Money Supply Affect Inflation?

The money supply of a country is a major contributor to whether inflation occurs. As a government evaluates economic conditions, price stability goals, and public unemployment, it enacts specific monetary and fiscal policies to promote the long-term well-being of its citizens. These monetary and fiscal policies may change the money supply, and changes to the money supply may cause 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.

Understanding How Money Supply Affects Inflation

The Federal Reserve is responsible for evaluating current market conditions and deciding whether to make changes to the money supply. The Fed makes changes to the money supply by lowering or raising the discount rate banks pay on short-term loans. The Fed also buys or sells securities from banks to increase or decrease the amount of money these banks have in reserves.

When the Fed increases the money supply faster than the economy is growing, inflation occurs. In this situation, the increase in money circulating in an economy is higher than the increase in goods produced. There is now more money chasing not as many goods in this economy.

For example, imagine an economy with $100 and 100 bananas. If everyone were to take their money and buy all bananas, the average price per banana would be $1. Now imagine the government increased the money supply by 10% to $110, but this fictitious economy was only able to grow banana output by 5% to 105 bananas. Since the amount of money increased more than the number of bananas, the average price per banana now increased to roughly $1.05.

Quantity Theory

The theory most discussed when looking at the link between inflation and money supply is the quantity theory of money (QTM).

The quantity theory of money proposes that the exchange value of money is determined like any other good - through supply and demand. 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. The equal is also called the Fisher Equation because it was developed by American economist Irving Fisher. In its simplest form, the formula is:

1 + Nominal Interest Rate = (1 + Real Interest Rate)(1 + Inflation Rate)

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.

Changes in the Money Supply Not Causing Inflation

There are several situations that occur where increases to the money supply does not cause inflation.

1. Economic growth may match money supply growth. If the level of economic growth is equal to the level of money supply growth, prices traditionally remain stable.
2. There are variations in the velocity of money circulating. In a recession, the Fed may choose to increase the money supply. However, spending patterns of consumers will vary during this period - including periods of decreased spending due to higher unemployment and less disposable income.
3. The economy has spare room to grow. During a recession, an economy is not operating at full capacity. Though an increase in the money supply provides additional resources, there may be minimal to no demand for additional capital as the economy grapples with stunted economic growth.

Other Impacts of Money Supply Changes

In addition to inflation, changes to the money supply may result in similar economic conditions. If the difference between the money supply and economic growth grows wide enough, the value of a currency begins to rapidly deteriorate and the country enters into a period of hyperinflation.

Alternatively, changes in the money supply can cause deflationary periods. The Fed can raise interest rates or decrease security purchases from banks. Both of these practices decrease the money supply. When the money supply decreases, there is less competition for goods and prices traditionally fall.

Example of Money Supply Impacting Inflation

As the world grappled with COVID-19, the Federal Reserve enacted policies to combat financial implications of the pandemic. In March 2020, the Fed announced it would keep its federal funds rate between 0% and 0.25%. It also announced plans to purchase at least $500 billion of Treasury securities over the coming months.

As the Fed continued to promote economic growth, the United States emerged from the pandemic. After peaking at 14.7% in April 2020, the nation's unemployment rate had dropped to 6.0% just twelve months later. After falling two consecutive quarters, GDP increased starting Q3 2020.

However, in exchange for promoting economic growth during this period, the nation began to experience price instability. In May 2020, the 12-month percentage change in the Consumer Price Index was 0.1%. Less than two years later, this rate was 7.9%. The nation had successfully navigated the economic downturn, but the growth in the nation's money supply had caused inflation.

The Bottom Line

When the Federal Reserve increases the money supply, inflation may occur. More often than not, if the Fed is attempting to stimulate the economy by growing the money supply, prices will increase, the cost of goods will be unstable, and inflation will likely occur.