There is quite a bit of evidence to support monetarists’ school of economic thought concerning the relationship between the amount of money in circulation and inflation.
Let’s look at a simple fictitious example. Suppose the Fed decided to print up and give to each adult $2 million. When you first get your $2 million checks you can’t believe your luck. What a deal! Remember though that everyone will get $2 million. That means that, like you, everyone will go out and begin buying all of those items they couldn’t afford. The problem though is that those items are limited. Production levels have not increased, only the amount of money people have has increased. This takes us back to our aggregate supply and demand curves – the demand curve shifts outward and to the right with corresponding HIGHER prices. AS PEOPLE DEMAND MORE AND MORE OF A SCARCE RESOURCE OR PRODUCT, THE PRICE OF THAT RESOURCE OR PRODUCT WILL INCREASE. Put another way, the value of the money that people have has fallen. Before the $2 million injections, a basket of economic goods cost the consumer $10. After the injection, the amount of goods in the basket has not changed but its price has risen to $100. The purchasing power of the dollar has decreased by 900% ((100-10)÷10). What used to cost $10 now costs 9 times that much (900% as much).
I’ve drawn a chart (Chart 18-A) to illustrate the effect that an injection of money into the economy might have on inflation:
Notice that the ‘y’ vertical axis on the left (up and down) shows the value of the dollar starting at $1 and moving downward to $.20. Look all the way to the right side and you’ll see the price level starting at $5 and moving upward to $25.
· Now, look at the vertical line labeled ‘Money Supply 1’. Point ‘A’ is the initial equilibrium point where the value of the dollar is at $33, and the price level is at $15.
· Assume that the Fed decides to begin purchasing bonds, putting more money into the hands of the consumer as well as lowering effective interest rates throughout the economy.
· This pushes the supply of money from ‘Money Supply 1’ to ‘Money Supply 2’.
· With this increase in the money supply, the demand for money begins to decrease from point ‘A’ to point ‘B’.
· As this occurs, the value of money (excess supply) has decreased from $.33 at point ‘A’ to $.20 at point ‘B’.
· Coinciding with this is an increase in the price level from $15 to $25. This is because there is a larger supply of money for consumers to spend, but the actual amount of goods and services to spend the money upon has not increased. The extra spending money for consumers has just given them the opportunity to bid up the prices of goods and services, which have remained the same in terms of quantity supplied.