Money Supply and Inflation

Follow us on LinkedIn In economics, there are two terms that closely relate to each other. These include inflation and money supply. The money supply in a country can have a direct effect on its rate of inflation. However, it is necessary to understand what each of these is before discussing their relationship.

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What is Money Supply?

Money supply refers to all currency and other liquid instruments included in a country’s economy on specific data. Usually, it consists of both cash and deposits that are highly liquid. Various factors can influence a country’s money supply. For example, the government issues currency through their central banks and treasuries. The public uses the currency, which they obtain from banks. The money supply is a crucial concept in economics, as it helps governments and analysts develop policies. They do so by considering the controlling interest rates and altering the amount of money flowing in the economy. They also perform public and private sector analysis to analyze the impact of money supply on the price level, inflation, and the business cycle.

What is Inflation?

In a country, inflation refers to the decline in the purchasing power of its currency over time. Usually, it comes in the form of a quantitative estimate of the rate at which this decline occurs. Analysts calculate inflation in a country by comparing the increase in the average price level of a basket of selected goods and services over time. Due to inflation, a country’s currency loses values as a result of higher prices. People can’t pay the same amount for the goods and services that they received in the past. In other words, they have to either pay higher or buy less. Inflation can cause various effects on a country’s economy. Similarly, inflation itself can be influenced by several factors, including money supply.

How are Money Supply and Inflation related?

A country’s money supply can have a direct impact on inflation. As the money supply rises, inflation can occur. However, for that to be true, the money supply must grow faster than the economic output within normal circumstances. Money supply can give rise to various events, which can all affect a country’s economy. Usually, an increase in a country’s money supply results in lower interest rates, which increases spending in an economy. The increased spending then results in a raise in other factors, such as the demand for labour. Similarly, the lower interest rates allow for capital to be available at better conditions. Through these, the money supply also gives rise to inflation.

What is the Quantity Theory?

The Quantity Theory of Money (QTM) explores the relationship between money supply and inflation. It suggests that the exchange value of money depends on supply and demand. It uses The Fisher Equation to describe the link. The formula is as below.

(M) (V) = (P) (T)

In the above formula, ‘M’ represents money supply and ‘V’ is the circulation velocity. ‘P’ shows the Average Price level and ‘T’ is the volume of transactions of goods and services. This formula shows the effect of money supply on inflation through nominal and real interest rates.

Conclusion

Money supply, in economics, refers to the amount of currency in circulation in a particular country. Inflation represents the decline in the purchasing power of a country’s currency over time. A country’s money supply can affect its interest rates which then gives rise to inflation. The Quantity Theory of Money explains the relationship between money supply and inflation.