Monetary Theory of Inflation

October 13, 2010Inflation

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Monetary Theory of Inflation in economics is known as the Quantity Theory of Money. The quantity theory of money studies the positive relationship between the Quantity of money and the Nominal Value of the expenditures. This can be also expressed as the maintenance of the positive relationship of overall prices.

History of Quantity Theory of Money
The seeds of the Quantity Theory of Money was embedded within the theories of Copernicus, Jean Bodin and many others who have contributed equally towards the formation of such a theory. All these people have recorded the increase in price of money after the import of gold and silver coins from the New World into the economy. John Stuart Mill propounded the "Equation of Exchange" which relates the supply of money to the value of money transactions. John Stuart Mill elaborated the ideas of David Hume. The Quantity Theory of Money actually owes its origin to the economists like Simon Newcomb, Irving Fisher and Alferd de Foville during the second half of 19th century and the first half of 20th century. However, the post-Keynesian era saw the restoration of the theory by the famous economist Milton Friedman.

Equation of the Quantity Theory of Money
The Quantity Theory of Money follows the equation of M.V= P.T where m stands for the supply of money, V represents the velocity of circulation, P stands for price level and T represents Transactions or output. According to the assumption of the monetarists V and T are constant and the growth of money supply are directly proportional to each other. Sometimes in an economy excess money is generated and this money might also get translated into inflation. There are different ways to translate this money. One of the common ways is when individuals spend their excess money directly in purchasing goods and services. Inflation is directly influenced by this factor by raising aggregate demand. This instance leads to imported inflation and finally culminate into cost-push inflation.
Principles of Quantity Theory of Money
The quantity theory of money follow certain principles. The principles are:
• The source of inflation is the increase in money supply
• The demand of money is a stable function of interest rates, nominal income etc.
• The supply of money is external
• The real interest rate is determined by time, productivity of capital.
• The inflow of money does not carry much importance in the long run

However, in the present days a school of economists think that the theory has lost much of its applicability. But it is still an important theory on which the analysis of inflation is based.