Monetarist Theory of Inflation

Monetarist Theory

Monetarists argue that if the Money Supply rises faster than the rate of growth of national income then there will be inflation.

· If money supply increases in line with inflation then there will be no inflation.

M.Friedman stated:

“ Inflation is always and everywhere a monetary phenomenon”

· Quantity theory of Money (fischer Version) MV=PT,

· M = Money Supply, V= Velocity of circulation, P= Price Level and T = Transactions.

· T is difficult to measure so it is often substituted for Y = National Income

· therefore MV = PY where Y =national output

The above equation must hold the value of expenditure on goods and services must equal the value of output. However they argue it is unwarranted increases in the money supply which cause inflation.

Monetarists believe that in the short term velocity (V) is fixed This is because I The rate at which money circulates is determined by institutional factors e.g. how often workers are paid does not change very much.

· M.Friedman admitted it may vary a little but not very much so it can be treated as fixed

· Monetarists also believe Output Y is fixed . They state it may vary in the short run but not in the long Run ( because LRAS is inelastic)

Therefore an increase in the Money Supply will lead to an increase in inflation

E.G. if MS is initially £1000 and the Velocity of circulation is 5. Level of output is 5000 units. The quantity equation is 1000*5 = 1*5000

If the money supply now doubles the equation = 2000*5 =2*5000 (the price level must double

· M. Friedman predicted an increase in the money supply would take about 9-12 months to lead to higher output
· After another year output will return to its initial equilibrium causing prices to rise to accommodate the rise in money supply

Cambridge Version of quantity theory states P= f(M)

Monetarist inflation in the AD and AS model

i) Following a rise in the MS, consumers have more money so spend more goods, this shifts AD to the right

ii) Firms respond by increasing output along SRAS, from A to B

iii) National output now exceeds the equilibrium level of output, therefore there is an inflationary gap.

iv) Firms need to hire more workers so wages rise leading to an increase in costs and hence prices. Initially workers agree to work more hours because they see an increase in nominal wages

v) As prices rise money can buy less therefore there is a movement to the left along the new AD

vi) Also workers realise the increase in nominal wage is not a real wage increase. Therefore, workers also demand higher nominal wages to produce more output and to compensate them for rising prices , therefore SRAS shifts to the left

vii) The economy has returned to the equilibrium level of output, but at a higher price level.

Therefore the rise in the Money Supply cause a rise in AD, But because the LRAS is inelastic there is no increase in therefore this is known as demand pull inflation.

Essays and Revision Notes on Inflation

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