Monetary inflation

Monetary inflation

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Monetary inflation is a sustained increase in the money supply
Money supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...

 of a country. It usually results in price inflation, which is a rise in the general level of prices of goods and services . Originally the term "inflation" was used to refer only to monetary inflation, whereas in present usage it usually refers to price inflation. Members of the Austrian School
Austrian School
The Austrian School of economics is a heterodox school of economic thought. It advocates methodological individualism in interpreting economic developments , the theory that money is non-neutral, the theory that the capital structure of economies consists of heterogeneous goods that have...

 of economics make no such distinction, maintaining that monetary inflation is inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...

.

There is general agreement among economists that there is a causal relationship between the supply and demand
Supply and demand
Supply and demand is an economic model of price determination in a market. It concludes that in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers will equal the quantity supplied by producers , resulting in an...

 of money, and prices of goods and services measured in monetary terms, but there is no overall agreement about the exact mechanism and relationship between price inflation and monetary inflation. The system is complex and there is a great deal of argument on the issues involved, such as how to measure the monetary base
Monetary base
In economics, the monetary base is a term relating to the money supply , the amount of money in the economy...

, or how much factors like the velocity of money affect the relationship, and what the best monetary policy
Monetary policy
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...

 is. However, there is a general consensus on the importance and responsibility of central banks and monetary authorities in affecting inflation. Keynesian economists favor monetary policies that attempt to even out the ups and downs of the business cycle
Business cycle
The term business cycle refers to economy-wide fluctuations in production or economic activity over several months or years...

. Currently, most central banks follow such a rule, adjusting monetary policy in response to unemployment
Unemployment
Unemployment , as defined by the International Labour Organization, occurs when people are without jobs and they have actively sought work within the past four weeks...

 and inflation (see Taylor rule
Taylor rule
In economics, a Taylor rule is a monetary-policy rule that stipulates how much the central bank should change the nominal interest rate in response to changes in inflation, output, or other economic conditions. In particular, the rule stipulates that for each one-percent increase in inflation, the...

). Followers of the monetarist school
Monetarism
Monetarism is a tendency in economic thought that emphasizes the role of governments in controlling the amount of money in circulation. It is the view within monetary economics that variation in the money supply has major influences on national output in the short run and the price level over...

 advocate either inflation targeting
Inflation targeting
Inflation targeting is an economic policy in which a central bank estimates and makes public a projected, or "target", inflation rate and then attempts to steer actual inflation towards the target through the use of interest rate changes and other monetary tools.Because interest rates and the...

 or a constant growth rate of money supply, while Austrian economists advocate the return to free market
Free market
A free market is a competitive market where prices are determined by supply and demand. However, the term is also commonly used for markets in which economic intervention and regulation by the state is limited to tax collection, and enforcement of private ownership and contracts...

s in money, which would entail free banking
Free banking
Free banking refers to a monetary arrangement in which banks are subject to no special regulations beyond those applicable to most enterprises, and in which they also are free to issue their own paper currency...

 or a return to a 100 percent gold standard
Gold standard
The gold standard is a monetary system in which the standard economic unit of account is a fixed mass of gold. There are distinct kinds of gold standard...

 and the abolition of central bank
Central bank
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...

s.

Quantity theory


The monetarist explanation of inflation operates through the Quantity Theory of Money
Quantity theory of money
In monetary economics, the quantity theory of money is the theory that money supply has a direct, proportional relationship with the price level....

, where M is Money Supply, V is Velocity of Circulation, P is Price level and T is Transactions or Output. As monetarists assume that V and T are determined, in the long run, by real variables, such as the productive capacity of the economy, there is a direct relationship between the growth of the money supply and inflation.

The mechanisms by which excess money might be translated into inflation are examined below. Individuals can also spend their excess money balances directly on goods and services. This has a direct impact on inflation by raising aggregate demand. Also, the increase in the demand for labour resulting from higher demands for goods and services will cause a rise in money wages and unit labour costs. The more inelastic is aggregate supply in the economy, the greater the impact on inflation.

The increase in demand for goods and services may cause a rise in imports. Although this leakage from the domestic economy reduces the money supply, it also increases the supply of money on the foreign exchange market thus applying downward pressure on the exchange rate. This may cause imported inflation.

Austrian view


The Austrian School
Austrian School
The Austrian School of economics is a heterodox school of economic thought. It advocates methodological individualism in interpreting economic developments , the theory that money is non-neutral, the theory that the capital structure of economies consists of heterogeneous goods that have...

 maintains that inflation is always and everywhere simply an increase of the money supply
Money supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...

 (i.e. units of currency or means of exchange), which in turn leads to a higher nominal price level, as the real value of each monetary unit is eroded, loses purchasing power and thus buys fewer assets and goods and services.

Given that all major economies currently have a central bank
Central bank
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...

 supporting the private bank
Bank
A bank is a financial institution that serves as a financial intermediary. The term "bank" may refer to one of several related types of entities:...

ing system, money can be supplied into these economies
Economy
An economy consists of the economic system of a country or other area; the labor, capital and land resources; and the manufacturing, trade, distribution, and consumption of goods and services of that area...

 by means of bank-created credit
Credit (finance)
Credit is the trust which allows one party to provide resources to another party where that second party does not reimburse the first party immediately , but instead arranges either to repay or return those resources at a later date. The resources provided may be financial Credit is the trust...

 (or debt
Debt
A debt is an obligation owed by one party to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.A debt is created when a...

). Austrian economists believe that this bank-created credit
Credit (finance)
Credit is the trust which allows one party to provide resources to another party where that second party does not reimburse the first party immediately , but instead arranges either to repay or return those resources at a later date. The resources provided may be financial Credit is the trust...

 growth (which forms the bulk of the money supply
Money supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...

) sets off and creates volatile business cycles (see Austrian Business Cycle Theory) and maintain that this "wave-like" or "boomerang
Boomerang
A boomerang is a flying tool with a curved shape used as a weapon or for sport.-Description:A boomerang is usually thought of as a wooden device, although historically boomerang-like devices have also been made from bones. Modern boomerangs used for sport are often made from carbon fibre-reinforced...

" effect on economic activity is one of the most damaging effects of monetary inflation. However, the Austrian theory of the business cycle varies significantly from mainstream theories with economists such as Gordon Tullock
Gordon Tullock
Gordon Tullock is an economist and retired Professor of Law and Economics at the George Mason University School of Law. He is best known for his work on public choice theory, the application of economic thinking to political issues...

, Bryan Caplan
Bryan Caplan
Bryan Caplan is an American economist, a Professor of Economics at George Mason University, Research Fellow at the Mercatus Center, adjunct scholar of the Cato Institute, and blogger for Econlog. He is best known for his work in public choice theory and for his libertarian ideology.-Personal...

, and Nobel laureates Milton Friedman
Milton Friedman
Milton Friedman was an American economist, statistician, academic, and author who taught at the University of Chicago for more than three decades...

 and Paul Krugman
Paul Krugman
Paul Robin Krugman is an American economist, professor of Economics and International Affairs at the Woodrow Wilson School of Public and International Affairs at Princeton University, Centenary Professor at the London School of Economics, and an op-ed columnist for The New York Times...

having said that they regard the theory as incorrect.

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