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 factors such as the velocity of circulation (number of times money changes hands), the state of the economy and the growth in productive capacity (the Long Run Aggregate Supply LRAS).

1. Growth of Real Output. Suppose the money supply increased by 4%. In a simplified model, this would lead to an increase in Aggregate Demand (AD) 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 other words the money supply can grow at the same rate as real output to maintain same price level.

However, if ceteris paribus, money supply grows faster than the rate of real output, it will cause inflation.

But, in the real world there are other reasons why an increase in the money supply does not lead to an increase in inflation.
2. Hard to Measure Money Supply. 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.

3. Velocity of Circulation


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.

4. Keynesian view – Liquidity Trap

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.

In a liquidity trap, interest rates fall to zero but this doesn’t prevent people saving. In this situation there is a fall in the velocity of circulation and this can cause deflation. In this situation, increasing the money supply will not necessarily cause inflation.

Summary of Link Between Money Supply and Inflation

  • In normal economic circumstances, if the money supply grows faster than real output it will cause inflation.
  • In a depressed economy (liquidity trap) this correlation breaks down because of a fall in the velocity of circulation. This is why in a depressed economy Central Banks can increase the money supply without causing inflation. This occured in US between 2008-11.  – Large increase in money supply no inflation.
  • However, when the economy recovers and velocity of circulation rises, increased money supply is likely to cause inflation.

Quantitative Easing and Inflation

Quantitative easing led to a big increase in the monetary base

US monetary base

The Federal Reserve created money to buy bonds from commercial banks. Banks saw a rise in their reserves.

However, commercial banks didn’t really lend this money out. Therefore the growth of the broader money supply didn’t change much

What happened is that commercial banks merely oversaw a rise in their reserves

The US inflation rate was largely unaffected by this increase in the monetary base. Stripping out volatile cost push factors (food and fuel), core inflation remained below 2% inflation target

us inflationSource: US CPI

Further Reading

28 thoughts on “The link between Money Supply and Inflation

  1. Well i think you were right in saying that all the money that was printed is kept in the banks for now. But what happens when the banks start lending again. What happens when this money starts to change hands in the economy. The answer is simple inflation.However, the people who are doing this are not the ones who have to worry about it as by the time this mess is sorted out and the banks start lending again they will all be out of office. On the other hand, those who will be in office at the time will have no other choice by to suck this money out of the economy and the result will be a dramatic increase in interest rates that would probably leave the economy crippled. Think Paul volker and the sluggish growth rates of the early 1980s. Now, no one knows exactly how interest rates will need to rise or how sluggish the economy would be. This is not to say that QE was a bad idea. QE was probably the only way out. However, this is just to say that QE has a price and sooner or later those countries that engaged in QE will need to pay that price. The only way to see whether or not this price was worth paying is to wait until these economies start functioning again.

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