Inflation is defined as "an increase in the overall level of prices in the economy" (Mankiw & Taylor, 2006, p. 817). The rate of inflation which is the percentage change in the overall level of prices, varies greatly from time to time depending on the condition of the economy and the stage of development of a country. Inflation is generally measured by calculating the cost of a basket of goods and services bought by an average consumer. This is measurement is represented in the form of an index known as the Consumer Price Index (CPI).
The rate of inflation is a cause of concern for policy makers, economists and the public alike. While most laypeople consider the existence of inflation to be undesirable, (because an increase in price levels without a corresponding increase in wages signifies a fall in purchasing power) economist tend to discount the much overplayed costs of inflation. To arrive at a conclusive opinion about the significance of the costs of inflation, it is first necessary to understand what causes inflation
The main reason behind cases of high or persistent inflation is the growth in the quantity of money available in the economy. Monetarists believe that changes in the quantity of money are a direct cause of inflation.
The quantity of money available in an economy is known as the money supply and is usually under the control of the government. The money supply in an economy is usually measured by the availability of currency (notes and coins), checkable deposits (demand deposits) as well as saving deposits, plus wholesale currency deposits, and in the broadest sense foreign currency deposits may also be included. Different measures of money are used according to need but the most common is M2 (Cash in circulation plus demand deposits). (Sloman, 1999, p. 560)
The quantity theory of money states that people hold money because they wish to engage in transactions to buy goods and services. The greater the need for transactions the greater will be the amount of money held. The amount of money held is expressed through the following equation, where M=quantity of money, V= velocity of money-the rate at which money circulates, P= average price of a transaction and T= total number of transactions over a period of time.
M V = P T
It is more useful and practical to substitute T with Y, which is the level of Output of an economy. The level of output will determine the number of transaction over a period of time and thus the equation changes to
M V = P Y
This equates the quantity of money available to the value of goods and services of an economy (GDP).
The velocity of money is held to be constant to make the model simpler. If one variable on the left side of the equation increases then there should be a corresponding increase in one of the variables on the right side. If velocity is taken to be constant, and level of output of an economy is taken to be a function of the factors of production, then any changes in M will result in corresponding change in the price level: P. Thus if an increase in money supply causes the nominal GDP to increase and the there is no increase in the output of goods and services then it is an obvious conclusion that the price levels have increased. The quantity theory thus implies that the price level is proportional to the money supply (Mankiw, 2003, pp.