What is the relationship between money supply and inflation?

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What is the relationship between money supply and inflation?

In the economy, inflation and the money supply correlate with each other. The money supply can be defined as notes and coins circulating outside the central bank. Inflation is a sustained rise in prices, which is normally measured by using the Retail Price Index otherwise known as the RPI. As money supply circulating around the economy increases inflation and balance of payments in turn also increases, however, this has very little effect on employment. The increase in money supply can be defined as the direct monetary transmission mechanism, which means that an increase in money supply leads to people spending the excess of their money supply over money demand. When people have more disposable income to spend on luxury goods aggregate demand also increases. Therefore businesses must increase the aggregate supply to give consumers what they want.

If the government wants to control and try to reduce inflation they would have to measure the money supply and use the fiscal policy in order to reduce the amount of money circulating around the economy. Inflation and the money supply effect consumer demand and increasing costs on a business. Too much spending leads to demand-pull inflation, Keynesians strongly argue that this is one of the major causes of inflation. This excess spending leads to an increase in demand that cannot be matched by the level of supply. As demand is greater than supply, prices will therefore rise. Businesses also experience increasing costs as money supply and inflation increase, which is known as cost-push inflation. As demand increases, labour costs may increase as workers and unions will push for an increase in wages.
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There are a number of policies that can be used in order to reduce the level of the money supply circulating around the economy which in turn will reduce the level of inflation.

Compare the relative merits of targeting the rate of inflation and targeting the rate of growth in the money supply as alternative objectives of the monetary policy?

There are many ways of targeting the rate of inflation. Some of which include the Fiscal Policy, the Monetary Policy, Supply-Side Policies and Demand-Side policies. The Fiscal Policy is aimed to manage the level of ...

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