Using the data and your own economic knowledge, discuss the extent to which increases in the money supply may increase the rate of inflation in an economy ( 25 marks)
Money supply is defined as the total stock of money in the economy; currency held by the public plus money in accounts in banks, inflation is defined as the general increase in the price level and a fall in the purchasing power of money.
It has been suggested the theory of the quantity theory of money which puts forward the idea that MV=PT whereby M= quantity of money in the economy; V= velocity of circulation; P= price level and T= volume of transactions i.e. essentially the speed at which money circulated the economy is equal to the price level at which the number of times the money changes hands. It became a basis of theory of which monetarists believe V and T are constant in the short run, only changing in the long run. In its simplest form, the quantity theory suggests a 10% increase in the money supply would lead to a 10% increase in inflation. Monetarists believe inflation is solely caused by increases in the money supply, no other factor e.g. rising oil prices would have influenced unless accompanied by an increase in the money supply and also that any increase in money holdings will be spent on real goods and services not bonds (believed by Keynesian economists).
The velocity of circulation in the long run will depend on how frequently people are paid- V will be higher if paid weekly; use of credit cards- the more often they are used the money will be in their possession for longer and so the bill is paid off at the end of the month and speculative demand for money- people may choose to buy bonds or save rather than spend reducing V.
Keynesians believe the speculative demand for money is sensitive to changed in interest rates- If rates rise people would have less incentive to spend as they would have a higher rate of return by saving rather than spending therefore reducing V, this will also happen if they purchase bonds. Whereas monetarists believe people will hold money for transactions rather than for speculative purchases. They also believe they money supply should only be allowed to increase at the same rate as money GDP (trend growth rate of 2.25%) therefore monetary policy should aim to control growth of money aggregates. However Keynesians believe a growth in the money supply simply accommodates inflation, but is not the cause.
In the 1980s, monetary policy aimed to control the money supply, however when the authorities try to control one measure of money e.g. M3, the relationship between that measure and economic activity broke down. Other financial assets took on the told of medium of exchange instead- control of the money supply had been abandoned- the central banks now target demand for money instead using interest rates.
Keynes, however holds a different view: he believes the velocity of circulation is not always fixed, in certain circumstances it could slow...