how money growth and inflation are related

how money growth and inflation are related

To understand how money growth and inflation are related, one needs to comprehend the two concepts separately. Inflation is the increase in prices of goods and services in the economy as a result of an increase in aggregate demand. When the demand for products and services increases relative to total supply, the providers will increase the prices. The more the increase in demand for goods and services, the higher the inflation in the economy. Many factors cause inflation, such as rising wages, high import prices, raw material prices, and high taxes. However, the role of money is significant in inflation patterns.

The classical theory of inflation considers money growth, which is an increase in money stock released into the economy by the state, to be a primary cause of inflation. Although money growth is necessary for inflation, it is not a stable condition for inflation. The money has to be spent by the people in the economy for it to affect inflation. Hence for money growth to fully affect inflation, the velocity of the money should be considered (Denbel, Fitsum, Yilkal &Teshome 561). For example, if a business person does business with the government, and the government prints $100 to pay the supplier, the money will not affect the economy if the businessperson does not spend it. Changes in money growth and velocity should be compared to the growth of goods and services provided to determine the effect on inflation. The results of inflation are measured by the Gross Domestic Product (GDP). Economic research shows that if money growth is equal to real GDP, then inflation is non-existent. Inflation occurs when money growth surpasses the real GDP growth. Hence an economy experiencing progressive expansions will allow the government to increase its money growth to cater to the expenses of the goods and services produced without fear for inflation.

I choose this specific topic because it helps one comprehend the essential concepts in money growth and how it affects inflation. Nominal GDP is a result of multiplication between the price of each good or services and its quantity (Denbel, Fitsum, Yilkal &Teshome 563). But since money is used in all transactions and the nominal GDP is equal to the value of all finished products and services, then the following relation holds Nominal GDP= Velocity x Quantity of money.

What I learned in researching the topic is that although the velocity of money varies over a while, it is relatively constant over the long-run. The fluctuations in money velocity over months or quarters can change the inflation over the short term. For economists to determine the trend of inflation in the economy, the velocity for money or variation in money growth has to be analyzed (Denbel, Fitsum, Yilkal &Teshome 565). Hence, to encourage consumer spending and entrepreneurship, a low inflation rate is required. Inflation should be negative. If the inflation rate is positive, businesses and consumers in the economy will hold money and as a result, suffocate economic growth. Also, I learned that inflation is directly related to the growth and velocity of money. Hence, prices of commodities increase when the government supplies more cash into the economy, and the money usage by those who receive it is fluid. In the short run, the real GDP and money velocity are equal. So, inflation is the same as money growth.

The real-world application of the topic to explain the relation of money growth and inflation can be demonstrated with the following example. Goodluck Enterprise supplies the government with security cameras worth $ 500.The government decides to print new notes and use them to pay Goodluck Enterprise. After receiving its payments, Goodluck Enterprise uses the money to pay its suppliers, WebCam Security Factory. Later, WebCam Security uses the amount to clear the employees’ wages and salaries.

In the example, the government has produced $500, which has completed transactions worth $2000.When businesses and individuals receive money, people’s propensity to consume also increased. Consumers’ higher propensity to consume increases aggregate demand, which increases prices. However, the change is not always as sudden as the effect of money growth, and velocity does take time.

Also, the government can increase money growth in the economy by using fiscal policy and monetary tools. The government, through the Federal Reserve, can decide to increase the bank reserve limits. The increase in the bank reserve will ensure commercial banks have more money in their volts to lend to the public. The banks will have to lower the interest rates to allow more people to borrow (Cukierman 112). The excess cash in the economy will increase people’s propensity to consume. The high demand as a result of money growth will increase the demand in the market and, ultimately, a hike in the prices of goods and services.

There are many complex factors affecting demand and supply, but money growth is significant. Economists have sought to explain the contribution of money variables to inflation, particularly the increase of money and the velocity for money.