Inflation is a sustained increase in prices of goods and services, with a direct relationship to the amount of money in an economy. The money supply and inflation are linked, and changes in the money supply are used to control inflation. Hyperinflation occurs when inflation rises extremely high due to a sudden increase in the money supply without an associated increase in the production or availability of goods.
Inflation refers to a sustained increase in the prices of goods and services. When inflation occurs, the purchase value of a monetary unit erodes, which means that a person needs more money to buy the same product. Most economists suggest that there is a direct relationship between the amount of money in an economy, known as the money supply, and inflation levels. Understanding the relationship between the money supply and inflation is far from easy or predictable, as inflation can be easily influenced by other factors as well.
The money supply and inflation are linked because a large amount of money generally devalues the demand for money. Imagine if everyone in a small town received a $50 US dollar (USD) raise in salary per month. These people may have been paying $10 a week for gas, but since their increase was substantial, now they probably wouldn’t mind paying $11 a week for gas, because it’s still proportionally less than what they were paying before the increase. This is sometimes how the relationship between inflation and the money supply begins, when the market can support higher prices because the money supply has increased, but a consumer cannot buy a product for the price it was before inflation occurred. due to the purchasing power of The currency has eroded.
The relationship between the money supply and inflation is explained differently depending on the type of economic theory used. In quantity of money theory, also called monetarism, the relationship is expressed as MV = PT, or Money Supply x Money Velocity = Price Level x Transactions. Speed and transactions are considered constant, so according to this explanation, supply and prices are directly related. In Keynesian theory, although there is still a relationship between the money supply and inflation, it is not the only important factor that can affect inflation and prices. In general, Keynesian theory emphasizes the relationship between total or aggregate demand and inflationary changes.
Changes in the money supply are often used to try to control inflationary conditions. When a region tries to reduce inflation, central banks will typically lower interest rates and raise interest rates. When inflation falls below a target level, these standards are generally relaxed in an attempt to stimulate the economy. Countries typically use a federal banking system to set loan and interest limits based on economic data.
The increase in the unreserved money supply can sometimes lead to a condition called hyperinflation. This occurs when inflation jumps extremely high in a short period of time, although the exact definitions are somewhat variable. Economists often say that hyperinflation occurs when inflation rises 50% in a month, but other estimates are used as well. The money supply and hyperinflation are linked because the condition can be the result of a sudden and massive dumping of money into an economy without an associated increase in the production or availability of goods. If, in the first example, the townspeople got a raise of $500 a month, then the price of gas could suddenly multiply many times over, causing an extraordinarily high level of inflation.
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