There is still no consensus on the relationship between inflation and money among economists. Early American economists Irving Fisher and Simon Newcomb put a simple theory that ‘the amount of money in circulation equals the money in national income’ (Boskin, 1997). This theory was however replaced by the Keynesian analysis with monetarists arguing that increases in prices would not cause inflation unless the government increased the supply of money in the economy. However, economists for a long time have observed that extended increases in prices of goods and services are related to increases in the nominal quantity of money. The dispute on the relationship occurs due to the fact that it occurs over a prolonged period such that it does not provide data for practical use by the policymakers and economists who are concerned with inflation over a short period of time.
The quantity theory
Inflation is the increase in the general level of prices. The link between money and inflation occurs on the basis of demand and supply of money. Today money is measured as the currency and deposits in financial intermediaries used in exchange. It also comprises deposits directly utilizable in trade. There are two fundamental parts in the relationship between inflation and money. These are Supply of money and demand for money (Harfer & Dwyer, 1999).
Supply of money
Central banks around the world have implemented policy actions that allow the use of nominal quantities of money which affect the supply of money. Such policy actions include changing the interest rates at which the central bank provides reserves to financial intermediaries, buying and selling government securities in the open market, and changing reserve requirements for financial intermediaries. The central banks affect nominal quantities of money in two ways. They buy government securities using currency thus increasing the money held by the public. They can also sell government securities to the public in exchange for currency which reduces the amount of currency in the hands of the public.
The demand for money
People require money to buy goods and services and therefore, firms’ and households’ demands account for a real quantity of money. If prices raise people to want to hold more money to buy the same amount of goods and services. Therefore if M is the nominal quantity of money and P is the price level, then the real quantity of money is M/P. The real quantity of money can be said to be a nominal quantity of money adjusted for inflation. Price levels are determined by general price indexes such as the GDP deflator and consumer price index.
Several factors affect the demand for money. The most important one is real income. A higher income is related to more spending which in turn makes it possible for holding of more money. The relationship between money demanded and real income is expressed as
where y is real income and k factor of proportionality, which is not constant.
The nominal interest rates also affect the demand for money. Nominal interest rates are the rate the banks pay. According to the fisher theory, the nominal rate of interest increases proportionally to inflation thus, a 1% increase in inflation results in a 1% increase in nominal interest rates. When consumers hold money they forego the real return that could be gotten from other opportunities for holding other assets such as government bonds. If the incomes rise the demand for money increases and when the interest rates rise the demand for money drops.
Other factors affecting demand for money include payment procedures and technological advancement in the financial sector. (Harfer & Dwyer, 1999).
The price levels
Discussion on the relationship between inflation and money would not be complete without a look at the price level. In the equation, M/P=k y, the nominal quantity of money supplied equals the quantity of money demanded. This depicts the relationship between variables; nominal quantity of money, price levels, and real income, and the other factors that affect the demand for money expressed as a factor of proportionality k. Constant real income and k provide a direct link between the nominal quantity of money and the price level. This equation could be expressed as
This equation seems idealistic but it creates a process for assumptions and analysis.
Real income changes over time affecting the demand for money. The determinants for real income are by a long shot unrelated to the demand and supply for money over long periods. These include factors such as growth in resources available for producing goods and services and technological developments. This makes real income autonomous from nominal quantities of money and price levels over long periods. Adjustments in real income, therefore, influence the price levels, but a proportional relationship exists between price levels and the nominal quantity of money in relation to real income (Boskin, 1997).
Advantages and disadvantages of inflation
Inflation also lowers the value of a currency which in turn lowers the actual value of debt thus benefiting indebted businesses, individuals, and institutions.
It also increases the value of stocks bought earlier which can be sold off at a higher price leading to higher profitability.
Inflation also results in a rise in the value of fixed assets which makes some businesses financially secure (South African Reserve Bank).
Disadvantages of inflation
It causes losses to savers who save by hoarding cash as the purchasing power of that savings grinds down. This affects mostly people who save in savings deposits which earn interest as it will not be enough to compensate in full for inflation and those who save through a pension scheme.
Inflation also results in losses to people with fixed incomes. These include those with fixed salaries and fixed deposits among others. As inflation increases, the purchasing power of their incomes decreases. In regard to this is the gap created between the poor and the rich. During inflation, the rich can invest in profitable assets such as shares and property while the poor continue to spend more to buy basic needs with the same salary.
Speculation which crowds out production can result from inflation. In an inflation environment, resources such as entrepreneurship are committed more to speculation in existing assets such as real estate rather than in the growth of production.
Inflation also leads to increased tension and social disruption in a country. The populace dedicates more energy to redistributive concerns as individuals or groups continually try to gain or regain a better price, wage, or position, which impacts negatively on societal structures. Moreover, inflation brings about uncertainty and confusion as it becomes harder to predict future prices and costs, which in turn delays investment decisions and long-term economic growth (South African Reserve Bank).
Boskin, M. J. Essays in Public policy: Inflation and its discontents. Stanford University, 1997.
Harfer, R. W. & Dwyer, G. P. Are Money Growth and Inflation Still Related? Economic Review, Second Quarter, Federal Reserve Bank of Atlanta, 1999. Web.
South African Reserve Bank. Why is inflation bad? Web.