The link between Money Supply and Inflation

Readers Question: When would an increase in the money supply not result in an increase in inflation?

The basic answer is that it depends on the growth in the Long Run Aggregate Supply.

Suppose the money supply increased by 4%. This would lead to an increase in Aggregate Demand of 4%. If AS (productive capacity) stayed static there would be no increase in Real Output, only inflation.

However, if the increase in AD of 4% was matched by an increase in AS of 4%, there would be no inflation, but, just an increase in real output.

In the real world there are other reasons why an increase in the money supply does not lead to an increase in inflation.
Sometimes the money supply is hard to calculate and is constantly changing. Large increases in the money supply are often just due to changes in the way people hold money, such as increase in credit card use may cause an increase in Broad money M4.

MV=PY

The quantity theory of money equation assumes that an increase in M causes an increase in P. However, this assumes that V is constant and Y is constant.
V (velocity of circulation)

However, in practices it is not as simple as this equation assumes. In practice there are variations in velocity of circulation e.t.c.

Keynesian view.

In a recession, there may be much spare capacity in the economy. Therefore, an increase in the money supply, merely helps to get unemployed resources used in the general economy. Therefore, in the case of a recession, increased money supply is unlikely to cause inflation.

Further Reading 

• Monetarist Theory of inflation
  
• Criticisms of Monetarism