Currency Increase and Inflation Course Summary and Formulas
In this article, I will summarize the key concepts and theories for understanding the relationship between money growth and inflation. Money growth is the increase in the amount of money in circulation in the economy. Inflation is the increase in the general price level of goods and services.
The most common theory used to explain the relationship between money growth and inflation is the **quantity theory**. According to this theory, there is a direct proportional relationship between the money supply and the total value of goods and services in the economy. We can express this relationship with the following formula:
$$MV = PY$$
In this formula, M is the money supply; V is the coin velocity; P is the price level; Y represents real national income. Money velocity is a coefficient that shows how many times money changes hands in a year. Real national income, on the other hand, is national income adjusted for price effects.
Among the variables in the formula, M and V are the factors under the control of the central bank. The central bank can increase or decrease the money supply using monetary policy tools. Money velocity, on the other hand, varies depending on the tendency of economic units to hold money. The central bank can affect the velocity of money by changing interest rates.
The variables in the formula, P and Y, are the factors determined depending on the market conditions. Price level indicates the average price of goods and services. Real national income shows the amount of goods and services produced in the economy.
According to the equation in the formula, an increase in the money supply or money velocity should lead to an increase in the price level or real national income. However, it is not possible for these two factors to increase at the same time. Because the production capacity in the economy is limited and real national income cannot increase further when it reaches its potential level. In this case, the entire increase in the money supply or money velocity is reflected in the increase in the price level. So inflation occurs.
According to this theory, the main cause of inflation is the excessive increase in the money supply. Therefore, in order to control inflation, the central bank must limit the money supply. To do this, the central bank can reduce the demand for money by raising interest rates, or it can set monetary policy rules so that the money supply grows in line with a specific target.
Money growth and inflation lecture summary
The explanation of the relationship between money growth and inflation with quantity theory has been subject to some criticism. Some of these criticisms are:
- Quantity theory assumes that the demand for money is constant. In reality, however, the demand for money varies depending on factors such as the interest rate, income level, and price expectations. Therefore, the effect of changes in the money supply on prices is not fixed.
- Quantity theory assumes that the money supply is completely controlled by the central bank. In reality, however, the money supply also depends on factors such as the banking system and the behavior of the public. Therefore, it is not enough for the central bank to determine the money supply alone.
- Quantity theory assumes that prices quickly adjust to market equilibrium. However, in reality, prices may deviate from the market equilibrium due to the lack of information of the participants, menu costs and contracts. Therefore, the effect of changes in the money supply on prices can be lagging and volatile.
Despite these criticisms, quantity theory provides a useful framework for explaining the long-run relationship between money growth and inflation. In the long run, it can be assumed that the demand for money is independent of factors such as the interest rate, income level, and price expectations. In addition, it can be assumed that prices approach the market equilibrium in the long run. In this case, the quantity equation can be written as:
M x V = P x Y
Here M is money supply, V is money velocity, P is price level and Y is real national income. If V and Y are considered constant, there is a direct proportional relationship between M and P. That is, the percent rate of change in the money supply is equal to the percent rate of change in the price level. This means that the inflation rate is equal to the money growth rate.
In summary, the quantity theory may be insufficient to explain the relationship between money growth and inflation in the short run. However, it shows that there is a close relationship between money growth and inflation in the long run.