The figure on the right shows the supply and demand of money. The demand curve is called liquidity preference schedule, its down sloped as there is an inverse relationship between rate of interest and quantities of money, given that at the high the rate of interest, firms and households tend to hold non-money assets such as bond or share; whereas supply of money remains constant, and is only changed by the bank of England in the context of UK market.
Within the next graph, one may assume that the central bank increases money supply, as result, there would be a fall in the rate of interest from R1 to R2.
According to the loadable fund theory, if it’s assumed that only demand for borrowed fund comes from firms or government willing to invest then the investment schedule is downwards sloping, conversely for the a rate of interest. At any given rate of interest, if households choose to save more, the equilibrium rate of interest in the economy will then reduce from r1 to r2.
Hence the lower interest rate, and greater investment, there could potential GDP growth and more employment opportunities; it may lead to greater consumption, and less incentive to consumption to save, and greater disposable income levels.
Also subsequently following the shift from Q2 to Q1, there ought to be major financial outflow, and greater inflationary pressure.
So, in short, the increase in money supply may lead to a fall in the rate of interest, which stimulates the investment towards the domestic economy, more investments means potentially higher inflationary pressure and higher AD; thus meaning a increase in the money supply could increase the rate of inflation.
However, the above are all derived on the bases that there is one market for money and only one equilibrium rate of interest within the economy; though in actuality, there are many markets for money and many rates of interest in economy such as one in the UK currently, due to the existence of high street banks partly. For example, banks lend each other at far lower rate than they do to normal borrower, as a result of less of relatively lower risks in the former. If all the markets were perfect, and all loans and borrowing were exactly same, the rate of interest would be the same always, but that’s far from reality, due quite to simples modeling.
Store of wealth may take many forms, there are just two official UK measure of money supply, the narrow and broad money; unlike the former, and the latter is less easily affected by the monetary policy. For that reason, I will be using M4 mainly for comparison. Looking at the graphs of M4 money growth of the last 10 years (second graph), and comparing it to that of CPI and RPI of the UK economy, there are definitely some resemblances between the trends in both graphs. Due to limited resources available at time of research, I was not able to plot both separate graphs on one line.
Especially, there seem to be quite similar shape between M4 and the RPI; for both lines are mostly upwards.
Analyzing from the data shown above, the rough outlook of RPI and M4 growth may be similar, one can argue that the lines are relatively out of phase, or perhaps as a result of different time-lags in real economy, a quite representative point might be the boom in the mid 2000.
And the inflation (RPI) line takes a far more violate line, which is a hint that not all inflation is resulted from change in money supply, or rather external factors also influence the inflation. There is also a matter of magnitude, it would appear to me that 2% growth in money supply would bring about only 1% inflation, thus might explain the seemingly less volatile M4 growth.
From what I can see on the first graph, it seems as if the interest rate adjusted by the MPC is more of a factor controlling the inflation than the money supply.
I think that while there is the resemblance between the graphs above, also the theory seems to suggest that more money supply should lead to higher rate of inflation; though I wouldn’t go as far as saying that all the increase in the inflation rate is solely caused by the increase in the money supply. For there is always time lag between increase in money supply and actual feedback; in an open economy, external factors does affect the inflation as well.
For example: the price of oil has grow drastically from Q2 last year until Q2 this year, to almost $150 per barrel, as result of the rising price level, the money supply started to grow at much lower rate, but the investment and confidence in the economy has not dramatically improved; after all money supply is a quite indirect monetary instrument comparing to the others. What’s more is the fact the rate of inflation, much against the theory of the monetary exchange equation, has raised up to 4.7% from Q1 this year, despite the fall in the money supply as seen on the graph, if the hypothesis was completely correct, would lead to lower inflation rate. It may appear that for the theory to work, the general demand for money have to be stable, where as currently, it’s not, especially with the economic outflow due to lower interest rate.
To another extent that I think the relationship listed in the title is not as simple as it seems, is the fact that compares to changing the money supply, the interest rate seems to be the primary, and more direct instrument used to control inflation by the MPC, and it has more relative effectiveness; also as the government is using more than one instrument at any given time, just as grass is not necessarily green, the result of one instrument can is very complex, and is virtually indistinguishable from the effect of another if used at the same time on such a large economy. Not to mention that consumer behaviour is far less linear than the theories suggest.
As seen on the graph, the CPI inflation appear to be much lower through the course of the last decade than RPI, which somewhat let us to question whether CPI is not as effective/realistic measure of inflation, or just easy scheme came up by the Labours government to meet inflation target of 2.0%; either way if in the question, the inflation is defined as RPI inflation, then I think that increase in money supply seem to have more sole effects than if CPI is used. I think that if I might have been able to find an RPIx graph, it would have been more helpful.
In the recent years, the government appear to utilise monetary measures over fiscal policies, looking at the current economic stance, of zero/negative GDP growth, and 4.7% of CPI inflation, one could argue that the monetary measures can only be so effective, and at the end of the day, due to lack of economic models, government may have to utilise more policies (ie: fiscal) at the same time frequently to intervene in order to achieve maximum economic as well as private and social benefit.
