What is the relationship between money supply and inflation?

Quick answer:

The generally accepted theory is that if the money supply expands faster than economic output, then the result is a period of inflation. Although there is significant historical evidence that supports this theory, modern economists are studying other factors that increase inflation more than those directly connected to the money supply.

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While much of economics and economic policy is hotly debated in the field, one area you find little disagreement is the effect of the money supply on inflation. Let's begin by expanding the definition of the money supply to include more than currency or cash. Credit in the form of credit cards, loans, and mortgages are part of the supply. Some economists include barter and exchange as well as currency. However, most economists do not consider barter or trade due to the less than a scientific method to account for the value of transactions. So, for this analysis, the definition of the money supply is currency, credit, and traditional loans like mortgages.

The generally accepted model, which historically is consistent, is that inflation increases as the money supply expands. The effect of the over-expansion of pumping cash into the economy is twofold. First, it lowers the value of the dollar. As the value of the dollar declines compared with foreign currencies, imports become more expensive. As a result, the US has a considerable trade, deficit importing far more goods than exporting. The price of the importing goods is passed to consumers in the form of inflation (higher prices). Another way to think of this phenomenon is the dollar's purchasing power is less.

The second effect relates to supply and demand. Milton Friedman postulates that inflation is less related to consumer prices rising from printing more currency but more closely related to the unemployment rate. As more money is pumped into the American economy, jobs increase, and more people can find work. Employed people spend more, having the effect of more cash chasing the same amount of goods until production catches up with demand. Thus, prices are driven up by supply and demand.

Finally, it is essential to remember the traditional methods of predicting inflation and money supply have been turned upside down in recent years by catastrophic events like the pandemic and market downturns. Technology has improved the accuracy of economic forecasting. New models analyzing the money supply and inflation are continually revised, updated, and reconceptualized. For example, one recent question under study is how cryptocurrencies like Bitcoin or the move by China to eliminate paper currency impact the money supply and inflation.

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