Money Growth and Inflation

What is the relationship between the rate at which the number of money increases and inflation? Does an increase in money supply always comes with an increase in inflation? What happens when the Fed buys securities for the market?

Money Growth and Inflation Money Growth and Inflation

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    You will be able to answer all these questions once you read our explanation of money growth and inflation.

    Money Growth and Inflation Summary

    A country's inflation level is proportional to the money supply in a country.

    The quantity of money available in the economy is one of the leading factors that determine the rate of inflation. The government and the Federal Reserve try to stay updated with economic developments to design a monetary and fiscal policy that effectively addresses the inflation rate. If the government or the Fed gets the policy wrong and injects too much money into the market, it will lead to high inflation. Although it may seem like printing money might be something cool to do to pay debts or wages, printing a lot of money is not in the economy's best interest.

    These monetary and fiscal policies may generate inflation by altering the money supply, which might be caused by changing the money supply.

    Money growth usually happens during an expansionary period when the Fed lowers the interest rate, boosting aggregate demand through consumption and investment spending. This, in turn, causes inflation in the economy to increase.

    During 2008, the Zimbabwean government was printing money at a scarily high rate. This caused the African nation to experience an increase of 11 million percent in the price level in just a year.1 To put it in perspective, if a bottle of water cost 1 Zimbabwean dollar in 2007, it would cost approximately 110,000 Zimbabwean dollars in 2008.

    It's important to note that an increase in the money supply for a sustained period will result in inflation. In contrast, a decrease in the money supply for a sustained period will result in deflation.

    Economists argue that money growth has only temporary short-run effects on the economy, but it does not affect the real long-run value of money. That is because an increase in money supply increases the price level, which keeps the real value of money constant.

    Relationship Between Money Growth and Inflation

    There is a positive relationship between money growth and inflation. As the quantity of money in the economy grows, the price level will also grow. Think about it, when there's tons of money in the market, and everyone gets a portion of it, their demand for goods and services will grow. However, that doesn't necessarily mean that the supply will grow. As more people are bidding more money for certain types of goods and services, businesses will respond by increasing their prices; in this way, money growth leads to inflation.

    The Quantity Theory of Money

    The quantity theory of money is one of the essential theories of monetary economics. The quantity theory of money suggests that as the number of money increases, the overall price level of goods and services in the economy increases. Additionally, the quantity theory of money states that the rise in the price level is proportional to the increase in the money supply. Hence, if the money supply increases by 7%, the price level will increase by 7%, while other factors remain the same. The quantity theory of money suggests that the growth rate of money supply determines the growth rate of the price level in the long run.

    The quantity theory of money is based on the assumption that the amount of money circulating in an economy significantly impacts the amount of economic activity taking place in that country. That is because it affects the economy's aggregate demand and supply by affecting the price level.

    An increase in the money supply would cause investment spending to increase as there is lots of money investors could inject into different stage startups or big companies. The funding that the startups receive is then used to hire more staff and expand, which then causes more goods and services to be consumed. Therefore, economic activity increases, also associated with an increase in the price level.

    Therefore, whenever you change the total amount of money that circulates in an economy, it will cause a shift.

    The quantity theory of money has several implications, one main one being that money loses value as inflation and money supply increase. As the money supply increases inflation, an increase in the money supply leads to a fall in the value of money. This can be observed in the example below:

    If $100 could get you 50 chocolate bars before an increase in money supply, $100 will get you 40 chocolate bars after an increase in the money supply. That means that the actual value of $100 has dropped.

    The primary strategy for establishing economic stability, according to monetary economics, is to exercise control over the available quantity of money. Because according to monetarism and monetary theory, shifts in the money supply are the primary factors that drive all economic activity. Governments should adopt policies that affect the money supply to stimulate economic expansion.

    The Neutrality of Money

    The neutrality of money is based on the idea that a change in nominal variables such as price level and wages does not impact real variables such as real GDP, which is the total output produced in the economy. According to the neutrality of money, while at full employment, a change in money supply will have short-run effects, but the long-run equilibrium output in the economy will remain unchanged.

    The classical model of the price level

    The classical price level model is a simplified model that suggests that the real quantity of money is always at its long-run equilibrium. That means that the price level and money supply do not influence the number of goods and services produced and demanded in the long run.

    To better understand how the classical model of price level works, let's consider the AD-AS model and how the long-run self-adjustment works. By the way, we have a great article on "the long run self-adjustment" process. Feel free to have a look at it!

    money growth inflation classical model of price level studysmarterFig 1. - Classical model of price level

    Figure 1 shows the short-run and long-run equilibrium in an economy using the AD-AS model.

    • AD is used to denote the aggregate demand curve.

    • LRAS is used to denote the long-run aggregate supply curve

    • SRAS is used to represent the short-run aggregate supply curve.

    Let's consider what happens when there is an increase in the money supply. An increase in money supply will cause the aggregate demand curve to shift to the right (from AD1 to AD2), moving equilibrium (from E1 to E2). This results in higher prices (from P1 to P2) and higher output produced(from Y1 to Y2).

    As prices increase in the economy, workers will demand increased wages to retain their purchasing power. As wages increase, firms' production cost increases, which shifts the SRAS to the left(from SRAS1 to SRAS2). This changes the equilibrium (from E2 to E3), resulting in overall higher prices(P3). However, notice that as the money supply has increased, only the price level has increased; the total output (Y1) has remained unchanged in the long run.

    The classical price level model ignores the short-run equilibrium (E2); rather, it assumes that the equilibrium moves directly to the long-run outcome (from E1 to E3) when there's an increase in the money supply.

    A drawback of this model is that when there's low inflation in the economy, it may take time for workers to increase their wages, resulting in more sticky wages. This means that the money supply does affect the real GDP in the short run.

    However, when there's high inflation, wages and prices tend to adjust much more quickly.

    The Effects of a Monetary Injection

    A monetary injection occurs in an economy in three main ways: reducing the discount rate, lowering the reserve requirement ratio, or engaging in open-market operation. To understand the effects of a monetary injection, let's consider what happens when the Fed does open-market operations.

    When the Federal Reserve engages in open-market operations to sell bonds, it does so in return for dollars, which reduces the total amount of money in circulation. When the Federal Reserve buys government bonds, it increases the amount of money in circulation and distributes dollars to the public. In addition, the money multiplier kicks into play when any of these dollars are deposited in banks, of which some are kept as reserves, and the rest are loaned out. As banks will have more money in their deposits, they can create more loans, creating even more money in the economy. As more money is available for lending purposes, it will cause the interest paid on loans to drop. This will cause consumption to increase like, say, for example, you can buy a house now while paying less interest. Additionally, investment spending will also experience an increase as it is cheaper for companies to borrow and invest. Hence, it will cause aggregate demand to shift to the right, which will cause the price level to increase.

    When the supply of money increases, as a result of increased demand or inflow of foreign investment or government policies, some level of inflation will occur. This results from more money in circulation than the value of goods; it can be thought of as a total good price equal to total money in circulation. Any adjustments to total money in circulation will change to the total good price. Overall the effect of a monetary injection is an increase in the overall price level in an economy.

    Money Growth and Inflation - Key Takeaways

    • Inflation results from a sharp increase in the money supply. The increase in the money supply raises prices and which leads to an increased quantity produced.
    • Deflation results from a fast decline in the money supply. This decrease in the money supply lowers prices, which disincentivizes producers to provide a higher quantity.
    • Changes in the money supply do not affect real variables such as GDP in the long run. Short-run price fluctuations have no bearing on the long-run output potential of an economy.
    • The quantity theory of money suggests that the growth rate of money supply determines the growth rate of the price level in the long run.

    Frequently Asked Questions about Money Growth and Inflation

    What is money growth and inflation?

    Money growth and inflation shows the relationship between the money supply and the price level in an economy.

    How does money growth cause inflation?

    When there’s more money in the market, demand for goods and services will grow. However, that doesn’t necessarily mean that the supply will grow. As more people are bidding more money for the same quantity of goods and services, businesses will respond by increasing their prices rather than running out of stock; in this way, money growth leads to inflation.

    What is a good example of money growth and inflation?

    During 2008, the Zimbabwean government was printing money at a scarily high rate. This caused the African nation to experience an increase of 11 million percent in the price level in just a year. To put it in perspective, if a bottle of water cost 1 Zimbabwean dollar in 2007, it would cost 110,000 Zimbabwean dollars in 2008.

    What is the relationship between money supply and inflation?

    There is a positive relationship between money growth and inflation. That means that as the quantity of money in the economy grows, the price level will also grow.

    How does an increase in the money supply affect the rate of inflation and interest rates?

    An increase in the money supply decreases interest rates and increases inflation.

    Test your knowledge with multiple choice flashcards

    What causes hyperinflation? 

    When the value of money drops, what happens to prices?

    Which of the following pushes the inflation rate into the negatives?

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