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 Can Inflation Be Good for the Economy?

    Find out why some economists and public policy makers believe that inflation is a good, or even necessary, phenomenon to ... Read Answer >>
  4. What is Inflation and How Should it Affect my Investing?

    Learn how the rate of inflation represents the rate at which the real value of an investment is eroded, and the loss in spending ... Read Answer >>
  5. What's the difference between agency theory and stakeholder theory?

    Learn how agency theory and stakeholder theory are used in business to understand common business communication problems ... Read Answer >>
  6. How does monetary policy influence inflation?

    Take a deeper look at how contemporary central banks attempt to target and control the level of inflation through monetary ... 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

    9 Common Effects of Inflation

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

    Monetarism: Printing Money To Curb Inflation

    Learn how Milton Friedman's monetarist views shaped economic policy after World War II.
  4. 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.
  5. Insights

    Is U.S. Inflation on the Horizon?

    Inflation, or the general price level of all goods and services in an economy, has remained subdued in the years following the Great Recession. Given recent developments, is the U.S. on the verge ...
  6. IPF - Banking

    How Inflation Affects Your Cash Savings

    Prices tend to rise over time and this inflation can cut into the value of your savings. Here are some ways you can manage the situation.
  7. Insights

    Inflation And Economic Recovery

    Inflation impacts the costs of every facet of the economy. Discover how it can help or hinder the economic recovery.
  8. Insights

    A Look at Fiscal and Monetary Policy

    Learn more about which policy is better for the economy, monetary policy or fiscal policy. Find out which side of the fence you're on.
RELATED TERMS
  1. Monetarism

    Monetarism is a set of views based on the belief that the total ...
  2. Accelerator Theory

    The accelerator theory is an economic theory whereby as demand ...
  3. Quantity Demanded

    Quantity demanded is used in economics to describe the total ...
  4. Neutrality of Money

    The neutrality of money is an economic theory that states that ...
  5. Money Supply

    The money supply is the entire stock of currency and other liquid ...
  6. Monetarist Theory

    The monetarist theory is a concept which contends that changes ...
Trading Center