Relationship between money supply and the inflation - Essay Example

?Introduction Money is one of the most important variables in macroeconomics and greatly affects the growth and price levels in an economy. It is because of this reason that it is argued that having an effective control over the money supply can actually result into the achieving of twin targets of growth and price control. (McConnell, Brue, & Flynn, 2008) One of the central debates in monetary economics therefore rests upon the neutrality of money and whether money can actually result into the development of price increase or not. This debate is also based on the notion that the central bank of a country actually does not have any role in contributing towards the economic growth because money actually remains neutral and does not result into the growth. What is actually however, discussed that the higher money supply can result into higher prices and thus if money supply is increased, it will create inflation in the economy and will hurt the real economic growth. This is because of the fact that higher inflation level decreases the purchasing power of money quickly. (Sloman, Hinde, & Garratt, 2010) How this relationship between money supply and inflation evolves and how actually the increase in money supply results into the inflation or general increase in price level is what will be discussed in this paper. The first section of the paper will discuss how the money supply is increased or decreased in the economy besides discussing what inflation is. Subsequent sections however, will discuss the relationship between the money supply and inflation and how both affect each other. Money Supply Central bank of any economy is considered as responsible for the money supply in the economy. The role of central bank is to ensure that the money supply is kept at a level which helps the State to achieve the objectives of economic growth and price stability. In order to achieve these objectives, central bank adapts different tools and techniques which help it to control the money supply in the economy. (Mankiw, 2002) One of the most commonly used methods is the open market operations under which central bank actually purchases or sells the government securities in the market. When government securities are sold in the market through open market operations, central bank actually attempts to reduce the money supply in the economy by mopping in the excess money from the system. However, when the government securities are purchased from the market, central bank actually inject money into the market thus increasing the money supply in the economy. (Mankiw, 2008) Another important method through which money supply can be controlled in the economy is the adjustment in the discount rate. Discount rate is the interest rate at which central bank lends to other banks and is also serves as the primary rate in any economy. When discount rate is increased, central bank therefore invariably makes it difficult for the households and firms to obtain the obtain money at relatively cheaper rates thus making borrowing costly. A decrease in the discount rates otherwise because by reducing the rate, central bank makes it easier for the firms and the households to borrow money easily. (Sloman, & Garratt.2010). Inflation and money supply Inflation is an increase in the general price level in the economy and signifies a reduction in the purchasing power of the money. Normally inflation is measured through a consumer price index where the prices of a fixed basket of goods and services are compared with the prices of the same basket of goods and services at a give base year. An increase in the prices as compared to the base year therefore is considered as an increase in the inflation and hence erosion in the purchasing power of money. A decrease in the purchasing power would mean money would buy fewer things. (Krugman & Wells, 2009) According to the classical economics, an increase in the money supply actually does not result into an equal increase in the aggregate demand for goods and services. As such any change in the money supply will therefore would not affect the economy and hence the role of central bank will not be effective. Classical economists also argue in such situation an increase in the money supply would result into inflation because when people have enough money, they would be willing to pay higher prices for the goods and services and thus increasing the inflation in the economy. (Arnold, 2007) The above graph suggests that when an economy is at the full employment level, a change in the aggregate demand would only result in an increase in the price levels in the economy because at full employment level, aggregate supply level remains the same i.e. vertical aggregate supply curve. A vertical aggregate supply curve therefore assumes that supply is fixed and will not change when economy is at the full employment level. (Sloman & Garratt, 2010) It is also important to note that equilibrium in the asset markets exists when the money supply is equal to the money demand. Under this condition, the price P is the ratio of the money supply and the money demand: P = M / L Where M is the money supply and the L is the money demand Thus at a given level of interest rates, real output level, a change in the money supply would result into an increase in the price level. Thus a change in the price level would therefore result into the change in the inflation and therefore result into the inflation if the price increase is positive. An increase in the inflation therefore reduces the nominal GDP and therefore the growth may not contribute to the economy as it should have been. (Abel & Bernanke, 2005) Conclusion The above analysis suggests that at the full equilibrium level, a positive change in the money supply would result into inflation and thus increase the general price level. A rise in the price level therefore results into the negative growth rates because when the impact of the higher inflation is incorporate into the growth rates i.e. GDP would decrease the nominal GDP and real output level may be less than the nominal GDP. Bibliography 1. Krugman, P. R., & Wells, R. (2009). Macroeconomics. New York: Worth. 2. Mankiw, N. (2008). Principles of Macroeconomics. New York: Gardners Books. 3. McConnell, C. R., Brue, S. L., & Flynn, S. M. (2008). Macroeconomics. New York: McGraw-Hill. 4. Abel, A. B., & Bernanke, B. S. (2005). Macroeconomics. New York: Addison Wesley . 5. Arnold, R. A. (2007). Macroeconomics. London: Cengage Learning. 6. Mankiw, G. (2002). Macroeconomics. New York: Worth Publishers Inc. 7. Sloman, & Garratt. (2010). Essentials of Economics. London: FT Prentice Hall. 8. Sloman, J., Hinde, K., & Garratt, D. (2010). Economics for Business. London: Financial Times/ Prentice Hall. Read More