Inflation can occur when the money supply outpaces economic activity in otherwise normal economic conditions. Factors other than the money supply can effect inflation, or the pace at which the average price of goods or services rises over time.
What role does money supply play in inflation?
When would an increase in the money supply not result in a rise in inflation, according to a reader’s question?
- Inflation is caused by increasing the money supply faster than real output grows. Because there is more money pursuing the same quantity of commodities, this is the case. As a result, as monetary demand rises, enterprises raise their prices.
- Prices will remain constant if the money supply grows at the same rate as real output.
Simple example of money supply and inflation
- The output of widgets increased by 20% in 2001. The money supply is increased by 20%. As a result, the average widget price remains at 0.50. (zero inflation)
- In 2002, the output of widgets increased by 16.6%, and the money supply increased by 16.6%. Prices are unchanged, with a 0% inflation rate.
- In 2003, however, the output of widgets increased by 14%, while the money supply increased by 42%. There is an increase in nominal demand as the money supply grows faster than output. Firms raise prices in reaction to the increase in demand, resulting in inflation.
When the money supply expands, what happens?
An rise in the money supply often lowers interest rates, which stimulates spending by generating more investment and putting more money in the hands of consumers. Businesses respond by expanding production and ordering more raw materials. The need for labor rises as company activity rises. If the money supply or its growth rate lowers, the opposite can happen.
What effect does money velocity have on inflation?
When the velocity of money rises, the velocity of circulation rises as well, indicating that individual transactions are becoming more frequent. A higher velocity indicates that a given quantity of money is being used for several transactions. A high rate of inflation is indicated by a high velocity.
What causes inflation when money is printed?
If you create more money and the number of items remains the same in normal circumstances (e.g. no shutdown, most people employed), we will see higher pricing.
This appears to be reasonable, however the current economic situation is totally different.
More detail on why printing money might not cause inflation
With the formula MV=PY, the quantity theory of money attempts to establish this link. Where
- Price level (P) would rise if V (velocity of circulation) and Y (output) remained constant.
- However, V (circulation velocity) is decreasing. People are staying at home rather than going out to shop.
Another approach to look at this issue is to consider why inflation is so unlikely when output is declining by 20%. (record level of GDP fall)
What is inflation in the money supply?
The amount of money in circulation determines the rate of inflation in the economy. When the supply of money in the economy expands, inflation rises, and vice versa. The central bank’s currency is, in fact, a responsibility of both the central bank and the government.
What causes price increases?
- Inflation is the rate at which the price of goods and services in a given economy rises.
- Inflation occurs when prices rise as manufacturing expenses, such as raw materials and wages, rise.
- Inflation can result from an increase in demand for products and services, as people are ready to pay more for them.
- Some businesses benefit from inflation if they are able to charge higher prices for their products as a result of increased demand.
Who is the hardest hit by inflation?
Inflation is defined as a steady increase in the price level. Inflation means that money loses its purchasing power and can buy fewer products than before.
- Inflation will assist people with huge debts, making it simpler to repay their debts as prices rise.
Losers from inflation
Savers. Historically, savers have lost money due to inflation. When prices rise, money loses its worth, and savings lose their true value. People who had saved their entire lives, for example, could have the value of their savings wiped out during periods of hyperinflation since their savings became effectively useless at higher prices.
Inflation and Savings
This graph depicts a US Dollar’s purchasing power. The worth of a dollar decreases during periods of increased inflation, such as 1945-46 and the mid-1970s. Between 1940 and 1982, the value of one dollar plummeted by 85 percent, from 700 to 100.
- If a saver can earn an interest rate higher than the rate of inflation, they will be protected against inflation. If, for example, inflation is 5% and banks offer a 7% interest rate, those who save in a bank will nevertheless see a real increase in the value of their funds.
If we have both high inflation and low interest rates, savers are far more likely to lose money. In the aftermath of the 2008 credit crisis, for example, inflation soared to 5% (owing to cost-push reasons), while interest rates were slashed to 0.5 percent. As a result, savers lost money at this time.
Workers with fixed-wage contracts are another group that could be harmed by inflation. Assume that workers’ wages are frozen and that inflation is 5%. It means their salaries will buy 5% less at the end of the year than they did at the beginning.
CPI inflation was higher than nominal wage increases from 2008 to 2014, resulting in a real wage drop.
Despite the fact that inflation was modest (by UK historical norms), many workers saw their real pay decline.
- Workers in non-unionized jobs may be particularly harmed by inflation since they have less negotiating leverage to seek higher nominal salaries to keep up with growing inflation.
- Those who are close to poverty will be harmed the most during this era of negative real wages. Higher-income people will be able to absorb a drop in real wages. Even a small increase in pricing might make purchasing products and services more challenging. Food banks were used more frequently in the UK from 2009 to 2017.
- Inflation in the UK was over 20% in the 1970s, yet salaries climbed to keep up with growing inflation, thus workers continued to see real wage increases. In fact, in the 1970s, growing salaries were a source of inflation.
Inflationary pressures may prompt the government or central bank to raise interest rates. A higher borrowing rate will result as a result of this. As a result, homeowners with variable mortgage rates may notice considerable increases in their monthly payments.
The UK underwent an economic boom in the late 1980s, with high growth but close to 10% inflation; as a result of the overheating economy, the government hiked interest rates. This resulted in a sharp increase in mortgage rates, which was generally unanticipated. Many homeowners were unable to afford increasing mortgage payments and hence defaulted on their obligations.
Indirectly, rising inflation in the 1980s increased mortgage payments, causing many people to lose their homes.
- Higher inflation, on the other hand, does not always imply higher interest rates. There was cost-push inflation following the 2008 recession, but the Bank of England did not raise interest rates (they felt inflation would be temporary). As a result, mortgage holders witnessed lower variable rates and lower mortgage payments as a percentage of income.
Inflation that is both high and fluctuating generates anxiety for consumers, banks, and businesses. There is a reluctance to invest, which could result in poorer economic growth and fewer job opportunities. As a result, increased inflation is linked to a decline in economic prospects over time.
If UK inflation is higher than that of our competitors, UK goods would become less competitive, and exporters will see a drop in demand and find it difficult to sell their products.
Winners from inflation
Inflationary pressures might make it easier to repay outstanding debt. Businesses will be able to raise consumer prices and utilize the additional cash to pay off debts.
- However, if a bank borrowed money from a bank at a variable mortgage rate. If inflation rises and the bank raises interest rates, the cost of debt repayments will climb.
Inflation can make it easier for the government to pay off its debt in real terms (public debt as a percent of GDP)
This is especially true if inflation exceeds expectations. Because markets predicted low inflation in the 1960s, the government was able to sell government bonds at cheap interest rates. Inflation was higher than projected in the 1970s and higher than the yield on a government bond. As a result, bondholders experienced a decrease in the real value of their bonds, while the government saw a reduction in the real value of its debt.
In the 1970s, unexpected inflation (due to an oil price shock) aided in the reduction of government debt burdens in a number of countries, including the United States.
The nominal value of government debt increased between 1945 and 1991, although inflation and economic growth caused the national debt to shrink as a percentage of GDP.
Those with savings may notice a quick drop in the real worth of their savings during a period of hyperinflation. Those who own actual assets, on the other hand, are usually safe. Land, factories, and machines, for example, will keep their value.
During instances of hyperinflation, demand for assets such as gold and silver often increases. Because gold cannot be printed, it cannot be subjected to the same inflationary forces as paper money.
However, it is important to remember that purchasing gold during a period of inflation does not ensure an increase in real value. This is due to the fact that the price of gold is susceptible to speculative pressures. The price of gold, for example, peaked in 1980 and then plummeted.
Holding gold, on the other hand, is a method to secure genuine wealth in a way that money cannot.
Bank profit margins tend to expand during periods of negative real interest rates. Lending rates are greater than saving rates, with base rates near zero and very low savings rates.
Anecdotal evidence
Germany’s inflation rate reached astronomical levels between 1922 and 1924, making it a good illustration of high inflation.
Middle-class workers who had put a lifetime’s earnings into their pension fund discovered that it was useless in 1924. One middle-class clerk cashed his retirement fund and used money to buy a cup of coffee after working for 40 years.
Fear, uncertainty, and bewilderment arose as a result of the hyperinflation. People reacted by attempting to purchase anything physical such as buttons or cloth that might carry more worth than money.
However, not everyone was affected in the same way. Farmers fared handsomely as food prices continued to increase. Due to inflation, which reduced the real worth of debt, businesses that had borrowed huge sums realized that their debts had practically vanished. These companies could take over companies that had gone out of business due to inflationary costs.
Inflation this high can cause enormous resentment since it appears to be an unfair means to allocate wealth from savers to borrowers.
Money supply can rise if
- Banks like to keep their liquidity ratios low. As a result, banks will be more ready to lend a larger amount of their capital.
- An influx of wealth from outside the country. If the Bank of England is required to purchase surplus pounds on the foreign exchange market in order to build up foreign reserves. This sterling will be used by foreigners to buy UK exporters, which will then be deposited in banks, resulting in the creation of credit, which will multiply the money supply. This will only happen if the B of E tries to keep the e.r below the equilibrium level.
- Because bank deposits are considered liquid assets, if the government sells securities to the B of E, the money supply will rise.
- If the er does not rise, the government will sell securities to foreign buyers, resulting in an increase in the MS.
- The Bank of England offers Treasury notes to the banking industry. These are considered liquid assets and can be used as a liquidity base for additional customer loans. As a result, the money supply will grow at a doubled rate.
- Bonds are sold by the government to the banking industry. Bonds are considered illiquid, and as a result, they will not be utilized as a basis for lending money.
- The government sells bonds or bills to non-banking financial institutions. If the public purchases something from the government, their bank deposits will be reduced, and the money supply will not expand.
- Fiscal policy that is expansionary. In a liquidity trap, lowering the liquidity ratio may not boost the money supply since banks and enterprises are unwilling to lend and borrow. There is sometimes a ‘paradox of thrift’ in the business world, with consumers wanting to increase their savings – which leads to a reduction in spending and investment. If the government borrows from the private sector and spends on public work investment programmes, a multiplier effect will occur, with families receiving wages to spend and private sector investment being encouraged.
Flow Of Funds Equation
- If we want to compare the size of the money stock at one point in time (Mst) to that at a prior point in time (Mst-1), we must look at the money flow (change) between these two points (change Ms)
- If the banking sector reduces its liquidity ratio in response to rising loan demand,
- If there is a surplus in currency flows and so a net influx from overseas. The portion of government borrowing that is funded by borrowing in foreign currency is also included in item four, which lessens the government borrowing’s expansionary effect.
The relationship between Money Supply and the rate of interest
Some monetary theories presume that money supply is completely unaffected by interest rates. Keynesian models, on the other hand, assume that:
- Higher credit demand will raise interest rates, making it more appealing for banks to extend credit.
- Depositors may be enticed to move money from sight to time accounts if interest rates are higher. The liquidity ratio can then be reduced by the banks.
When the money supply is reduced, what happens?
The term “expansionary” or “contractionary” refers to monetary policy that is either expanding or contracting. Contractionary policy aims to slow down economic growth, whereas expansionary policy aims to speed it up. In the past, expansionary policy has been employed to try to address unemployment during a recession by decreasing interest rates in the hopes of luring businesses into expanding. This is accomplished by raising the available money supply in the economy.
The goal of expansionary policy is to increase aggregate demand. Aggregate demand is the sum of private consumption, investment, government spending, and imports, as you may recall. The first two elements are the focus of monetary policy. The central bank stimulates private expenditure by raising the amount of money in the economy. The interest rate is reduced as the money supply is increased, which encourages lending and investment. A rise in aggregate demand is the result of increased consumption and investment.
It’s critical for policymakers to make trustworthy pronouncements. If private agents (consumers and businesses) believe politicians are devoted to economic growth, they will expect future prices to be higher than they would otherwise be. The private agents will then make adjustments to their long-term goals, such as taking out loans to invest in their firm. However, if the agents feel the central bank’s efforts are only temporary, they will not change their behavior, reducing the impact of the expansionary policy.
The Basic Mechanics of Expansionary Monetary Policy
There are various ways for a central bank to implement an expansionary monetary policy. Open market operations are the most common way for a central bank to pursue an expansionary monetary policy. The central bank will frequently buy government bonds, putting downward pressure on interest rates. The purchases not only expand the money supply, but they also encourage investment by lowering interest rates.
It is easier for the banks and organizations that sold the central bank debt to make loans to their customers since they have more cash. As a result, loan interest rates are lower. Businesses are likely to use the money they’ve borrowed to expand their operations. As a result, more jobs are created to build the new buildings and staff the new positions.
Inflation is caused by an increase in the money supply, yet it is crucial to remember that different monetary policy tools have varying effects on the level of inflation in practice.
Other Methods of Enacting Expansionary Monetary Policy
Increased discount window lending is another option to implement an expansionary monetary policy. The discount window allows qualifying institutions to borrow money from the central bank for a short period of time to address temporary liquidity shortfalls caused by internal or external disruptions. Reducing the discount rate, which is charged at the discount window, can stimulate more discount window lending while also putting downward pressure on other interest rates. Interest rates are low, which encourages investment.