Inflation and the Money Supply Essay Example | Topics and Well Written Essays - 2000 words

Inflation and the Money Supply - Essay Example Most of the economists indicate that one of the principal reasons of inflation is the unreasonable growth in money supply. The sources of this theory lie with Monetarist economists. Milton Friedman observed that, "Inflation is always and everywhere a monetary phenomenon," (Milton Friedman, 1987). The theory of inflation takes up the Quantity Theory of Money to propose that if the amount of money in the economy grows faster than the growth in the level of possible output, then this will affect upon the prices. In other words if the money supply grows too fast there will be inflation. The broad aim of this essay is to bring out the knowledge of the basic theory concerning the relationship between the growth of money supply and inflation in an applied context. This will demonstrate a clear understanding of both narrow and broad measures of the money supply and their linkages with relevant macroeconomic variables. Through analysis of relevant macroeconomics data which is taken from official data sources, a qualified conclusion concerning the relationship between inflation and money supply growth for a country is arrived. The main policy implications of the findings for the conduct of monetary policy are also carried out. The classical theory of monetary policy defines money as a medium of exchange. Money is utilized to carry out the dealings and it is indifferent in its affect on the economy. It cannot manipulate the real variable quantities like income, output and employment. On the other hand, the economy can determine the monetary variables like price level and monetary wages. Consequently the classical economists stated that price level is the function of money supply. This was explained with the help of the quantity theory of money. The level of prices will be double the quantity of money was the conclusion which they derived. Therefore any alterations in supply of money will affect the price proportionately. It is symbolised by the equation of exchange: MV=PY: Where M= supply of money, V= velocity or the number of times money turns over per time in the purchase of final output Y, P= price level of output Y. MV= PY is an identity element and hence can be written as MV= PY. This formula states that the amount of money multiplied by the number of times each unit of money on the average is expended to purchase final output at any given time. It is again multiplied by the price level of those goods and services that is PY. As Y constitutes GNP, P is the price level of the goods and services developed Y, and V is the number of times the money supply is used to purchase goods whose value is PY then GNP = C+I+G= MV= PY. The above theory can also be represented as: MV = PY, where V is the velocity of money. It is alleged to evaluate how often the money stock turns over in each period. It can also be written as: V = nominal GDP/nominal money supply, i.e., V = PY/M. MV = PY is treated as an identity and not an equation, since by the definition of V, it must always true. When there are alterations in M, P, or Y, then V may have to adapt. Empirically, the V in the identity above is not required to be a constant. If we assume that V is a constant, then we have the QTM, which can be tested empirically. The new version of the QTM is