How do Changes in the Money Supply Effect Inflation?
I understand that demand in excess of supply is a cause of inflation and I've heard that inflation is when too much money chases too few goods (if I remember that line correctly). But what exactly does this mean in layman's terms? How does increasing the money supply effect, for example, the price of a gallon of milk or gasoline?
In advance, thank you for any help received.
Answer:
The tricky thing with inflation is that there are two different things that are meant when people say "inflation".
The first one is the "too much money chasing too few goods" inflation (the cause). Say there is $100 in the economy. If the government increases the money supply to $200, there is suddenly too much money in the economy for the goods there were before. Thus, prices rise as money is now basically worth half as much (it is twice as "easy to get").
The second one is the simple inflation of prices over time (the effect). When the Fed and people on the news talk about the "headline inflation number", etc. they are talking about the percent rise in prices (since some previous date). Since it is much easier to observe inflation through this effect (and not its cause, the money supply), this is what people are usually talking about.
(Going a bit deeper here) As the other answerer mentioned, the way this is all controlled is through interest rates. The Federal Reserve is the controller of the U.S. money supply (our central bank), and they watch inflation very closely. They then set an interest rate at which banks can lend from them. This rate then moves through the economy and causes inflation to either slow down or speed up, depending on what they feel the health of the economy is.
Hope this helps, and is not too much. Once I get going, I tend to write a lot :) Please feel free to shoot me an email through my profile with any questions... I would be happy to answer them.
if you increase the amount of money in circulation, you can be decreasing it's value.
So it means if you are buying imported goods,they become more expensive, as the money is worth less.
However it also means your exports are cheaper.
If you continue to put more money into circulation, either by excessive loans or credit, and the value weakens, the international banks could loose faith in it and it will weaken further. To stop this the banks increase interest rates, making loans and credit dearer, so in order to pay the extra interest, the milk, or gas supplier puts up its price.
very simple terms, hope this helps
As you increase the money supply, you decrease the value of the currency and erode it's purchasing power. As the value/purchasing power erodes, you need more of the currency to buy the goods you're seeking.
For example, let's say you have a widget for sale and you want to sell if for $1. I have a $1 bill and the bill is actually worth $1, so I give you the $1 and you give me the widget. But now, let's say the central bank pumps in so much money that that $1 bill has lost so much value/purchasing power that it's now only worth 5 cents. So, you have a widget for sale which is $1, but the $1 I have only has the purchasing power of a nickel, so in order for you to get a true $1 in purchasing power, I'd have to give you $20 ($0.05 x 20 = $1) to purchase that widget. To the casual observer, this looks like the price of the widget went up, but in reality, the value/purchasing power of the currency has gone down, thus you need more of the currency to maintain the same purchasing power.
Yes, you can get into the argument that there is more money chasing fewer goods, thus consumers bid up prices, but I think that's an over simplification of the process. Price inflation is a direct function of monetary inflation. Prior to the creation of the Fed in 1913, inflation was near 0%. It wasn't until after 1913 that inflation started to increase.
Also, some may argue that the above scenario of printing money isn't valid as it takes years/decades for prices to increase substantially. Then how do they explain the Post WWI Wiemar Republic Germany hyperinflation? In a period of just 2 years, the Germans had printed so much money that the exchange rate of the Reichmark to the US Dollar went from about 4 or 5:1 to 2.4 trillion:1. In that 2 year time period, the price of 1 oz. of silver went from 12 Reichmarks to 580 billion Reichmarks and 1 oz. of gold went from 170 Reichmarks to 87 Trillion Reichmarks - all because they printed way too much money.
If you look at the current statistics, the dollar has lost 97% of it's purchasing power. In other words a $1 bill actually only has the purchasing power of 3 cents.
Now, the second poster mentioned interest rates as a means of controlling inflation. Actually, that's the lesser of the two tools the fed has. The greater tool is the Fed's Open Market Operations, ie, the mechanism they use to add liquidity to the system. Interest rates are the COST of money, while the Open Market Operations are the AVAILABILITY of money. If the fed really wanted to fight inflation, they'd use both, increase interest rates AND remove liquidity from the system. Alas, the fed is increasing the money supply at record setting paces - why do you think they stopped publishing M3 data back in March '06?
So, in the most simple terms, the more you increase the money supply, the more you decrease the value/purchasing power of the currency, therefore, you need more of the currency to maintain purchasing power. To the casual observer, it looks like prices of good has gone up, but in reality, the value/purchasing power of the currency has gone down, thus needing more of the currency to purchase the same amount of goods.
Hope this helps.
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